Days Sales Outstanding (DSO) is a poorly known yet key indicator in managing and improving your cash flow. If you want to know more about what DSO is, how to calculate it and work on DSO improvement, the following is a close-up on these three letters that will help you implement an efficient and balanced credit risk policy.
The Days Sales Outstanding, for a given company, is the average time of payment for its commercial invoices. In other words, DSO is the average number of days it takes you to collect payment for a sale.
For example, if your DSO is equal to 32, it means it takes you 32 days on average to collect payment from your customers after sales.
If you frequently use trade credit, it is a central indicator for assessing your ability to receive payments on time. Given the vital importance of cash flow to run your business, it is of course in your best interest to collect your outstanding account receivables as early as possible. By quickly transforming sales into cash, you can use or invest this cash more quickly.
You can calculate DSO every month, every quarter or on an annual basis, for your whole customer database, but also for a specific customer. It can for example help you identify the customers that take the longest time to pay you.
Wondering how to calculate DSO? The DSO formula works as follows, for a given period:
DSO = (accounts receivables / total sales) * number of days
For example, over the month of January, ABC Ltd has sold for €50,000 worth of goods, with €35,000 in accounts receivable on its balance sheet at the end of the month.
What is its DSO? The DSO calculation is: (35,000 / 50,000) * 31 = 22.3 days. It means that on average in January it took ABC Ltd 22 days to collect payment after a sale had been made.
The DSO formula takes only credit sales into account. Cash sales are not included in the DSO calculation and could be considered like having a DSO equalled to 0.
The DPO (Days Payable Outstanding) is your mirror indicator: it allows you to see how many days you take on average to pay your invoices.
DPO = (accounts payables / cost of goods sold) * number of days
For example, over the year 2019, Star Fresh has spent £280,000 worth of COGS, with £30,000 in accounts payables on its balance sheet at the end of the year. Its DSO is: (30,000 / 280,000) * 365 = 39.1 days. It means that on average in 2019 it took Star Fresh Ltd 39 days to pay its bills and invoices to its creditors (suppliers, vendors, etc.)
So when considering DSO vs DPO, remember that DSO is the average number of days it takes your customers to pay you, while the DPO is the average number it takes you to pay your suppliers.
The DSO allows you to assess your ability to convert your trade receivables into cash. These, along with inventories, make up the main element of your working capital.
The higher your DSO, the greater your working capital, and the lesser your free cash flow.
To that effect, the DSO is a key indicator of the financial health of your company.
Now that you know how to calculate DSO, you need to know how to interpret it.
DSO improvement only makes sense in relation to your business strategy. In theory, a company or a sector that is accustomed to selling on credit will have a higher DSO.
As with working capital, the variation of the DSO from one period to another is what counts, more so than its absolute value.
Example 1: Company A is used to selling on credit on its domestic market – usually around 10 days – but is now expanding to a foreign country, with a large customer that turns out to take longer to pay the invoices – about a month. Company A’s average DSO is going to go up from 10 to 15 days.
Example 2: Company B has a loyal and regular customer base and usually allows a payment term of one month. For several months, its DSO has stabilised at roughly 30 days.
In this case, it is company A that must be particularly careful, despite a lower DSO: its ability to be paid on time, and therefore its free cash flow, has deteriorated. Company B however is aware of its average DSO and has anticipated it.
Financially speaking, it is always good to lower your DSO. However, it can be beneficial commercially to offer your clients an attractive trade credit policy, which will mechanically raise your DSO. To get tips on finding the sweet spot between protecting your financial situation and offering attractive terms, have a look at our article on how to negotiate payment terms.
It is up to you to define your business strategy: the objective is to define a target for your DSO improvement that is adapted to the reality of your business and your company.
To that effect, you can evaluate the following criteria:
- The creditworthiness of your clients: how well do you know them? What is their payment history with you or with other suppliers? To go further, read our article on how to assess your customers' creditworthiness on our US website.
- Recent changes in your working capital: has it shot up in recent months? Can you afford to reduce your free cash flow? For more in-depth knowledge on cash flow, check out our ebook How to protect your cash flow.
Once your target DSO has been set, the goal is then to stick to it as best you can and review it regularly, especially when you enter work with new customers or a new market.
There are several ways for DSO improvement:
- Negotiate better payment terms: set up shorter payment terms, advance payments, early payment discounts…
- Strengthen your invoicing process: improving DSO often requires a focus on making sure that invoices are going out on time, contain all necessary information and are free of errors.
- Better manage accounts receivables: invest in efficient payment monitoring to remind customers of unpaid invoices, and define a clear recovery processes – if necessary through a debt collection agency or your trade credit insurance provider.
Trade credit insurance remains one of the most efficient solutions to ensure the stability of your DSO. With trade credit insurance, you are insured in the event that a credit cannot be recovered. As a result, you are guaranteed that a potential bad debt will not have a negative impact on your working capital. Read our article on how credit insurance helps to secure your cash flow to learn more.
In conclusion, more than lowering your DSO, it is important that you keep it under control: a rising DSO is a sign that you are no longer in control of your invoicing and debt collection process and that your financial health is deteriorating. It is therefore important to constantly monitor it and work on improving it while maintaining good relations with customers.
