Days Sales Outstanding, or DSO, helps business owners assess how well they are collecting on outstanding accounts receivable. Any business that invoices customers and sets payment terms should monitor their DSO closely because the more time is spent waiting to collect cash, the more effort (read: money) is ultimately required. Not only that, a high DSO can signal that there may be other problems within the business that need addressing.
To calculate your DSO, determine the length of time you would like to analyze. We recommend at least three months to get an accurate average. Insert your accounts receivable from the balance sheet and net sales over the period from your income statement, and then select the window of time you’d like to analyze.
The result will show the average number of days it takes your company to collect payment from outstanding invoices.
What Is Days Sales Outstanding (DSO)?
As long as people have been trading goods, they have been using invoices to show outstanding debts. Sending invoices to customers for goods or services is common practice for most businesses, with the exception of retail or restaurants where transactions take place immediately.
And after invoices have been sent out for payment, they must then be collected.
The process for collecting an invoice may be as simple as sending a reminder email or as complex as engaging a collections agency for help. And there are a number of factors that could drive the collection of an invoice to the complex side of the spectrum, including poor collections processes, invoice errors, failures to deliver on the goods or services paid for, or cash flow issues on the customers’ side. Any one of these circumstances could cause the amount of time to collect an invoice to lengthen.
That’s where days sales outstanding comes in.
Business owners who regularly send invoices can monitor their DSO on a regular basis to ensure that they are collecting invoices in a timely manner. When they notice that their DSO is higher than in the past (or higher than the industry average), they may take further steps to investigate what’s causing the hold up.
To calculate days sales outstanding by hand, you will want to look at your accounts receivables and net sales over a defined period of time. We recommend reviewing DSO over at least three months to get an accurate average. Many business owners will opt to look at their days sales outstanding over the last year for the sake of simplicity.
Like all accounting metrics this one should be calculated more often than once a year. However, if you have the data available from your financial statements, the longer the time period, the more accurate your average will likely be (barring any major outliers).
Once you’ve determined your time frame, use the below formula to calculate your DSO.
DSO = Accounts Receivable / (Net Sales / # of Days)
Let’s break down this formula further with some definitions of the key metrics involved.
- Accounts Receivable: Your accounts receivable live on the balance sheet and is independent of the time frame you selected. It shows all the money you are currently owed by customers.
- Net Sales: Net sales can be found on an income statement. The income statement shows performance over time, so you will want to find the cumulative net sales over the period you have selected. As a reminder, net sales shows all the revenue that was brought into the business from sales, less any returns, allowances, or discounts.
Once these numbers have been located and added to the formula, the result shows an average number of days to collect.
If a construction company, for example, invoices customers on 60-day terms for their projects, they may be curious to know if they are collecting near the date of their set terms or if there is room for improvement. To find out, they review their balance sheets and income statements from the last six months and find:
- Accounts Receivable: $350,000
- Net Sales: $1,000,000
Plugging these numbers into the DSO calculation, they see:
DSO = $350,000 / ($1,000,00 / 180)
DSO = 63
For 60-day terms, meaning their customers can take up to 60 days to pay, a DSO of 63 is not too shabby. As we’ve shown, there are many reasons why some customers may pay late. The closer the DSO calculation is to the terms that are set and the industry averages, the better.
DSO Benchmarks by Industry
Industry averages play a big role in understanding days sales outstanding. If a food manufacturer selling food to grocery stores and retailers calculated a DSO of 63, it would likely spell trouble for their business. And yet, for the construction company, it’s a perfectly reasonable number.
Industry standards for DSO can vary widely. The Engineering & Construction and Food industries show a stark contrast in what an acceptable DSO looks like, as shown by the median number of days it takes each to collect payment. As of 2016, the Engineering & Construction industry took approximately 82 days to collect on invoices. Meanwhile, the Food industry took only 27 days.
As a business owner, it’s important to know and understand the DSO standards for your industry. Pay attention to the terms your competitors set. Are they lower than yours? If so, ask yourself what incentive you have to keep your terms longer.
For most businesses, a low DSO that hovers around 30 likely means your business is collecting quickly and is in good shape. If the number crosses 45 (and you’re not in an industry with a higher DSO average), there may be some systemic issues that need to be addressed within your organization.
What Does DSO Mean for Your Business Operations?
The reason that paying close attention to changes in days sales outstanding is important is not just that it can signal some procedural issues within the company but primarily that any time cash coming into the business slows, cash flow issues may arise. Companies seeing an increase in their DSO need to keep a close watch on cash flow to make sure that they can pay their own financial obligations on time.
They also need to take immediate steps to address the issue before cash flow problems become a serious threat.
Common Causes of DSO Changes
A sharp increase in credit sales volume typically signals a shift in days sales outstanding. This could be the case for many reasons, like not having the proper infrastructure in place to deal with the larger-than-normal volume or simply seasonality.
A longer DSO may also signal that the sales team is selling to customers with poor credit, who are less likely to pay their invoices. While the sales numbers look good in the moment, this method of selling can cause negative ripple effects throughout the company. To combat this, ensure that there is an adequate way for those responsible for invoicing to voice feedback to sales and leadership.
In many cases, customers have the money to pay but simply withhold payment because they are dissatisfied with something. This may be that they’ve noticed errors on their invoices or take issue with the products or services that were presented to them. A growing number of disputed invoices ought to signal to leadership that they should investigate the issue.
However, while invoices are in dispute, companies can—and should—request payment for the undisputed portions of the invoice. If a customer takes issue with the discounted rate you offered on one line item, for example, you should still attempt to collect on all other line items and remove the disputed section until it can be resolved independently.
Whether you have a team collecting invoices or you handle it yourself as the business owner, your business needs a repeatable, easy-to-manage process for invoice management. The solution you use to send invoices will ideally allow you to set automatic reminders, so that you don’t have to remember to send follow-ups before the payment is due.
Your invoicing solution should also quickly show you all outstanding invoices and when they are due, so that you can determine at a glance which customers warrant a personal touch, like a phone call to check on their payment.
And finally, if cash flow concerns are starting to crop up, it may be worth examining your payment terms. If they are above industry average, that’s a clear sign that you can likely shorten your terms without ruffling any feathers. If your customers have ever purchased from a competitor, they’ll already be accustomed to those terms.
As a general rule of thumb, payment terms are tightening across the board. Now, nearly 75% of invoices are due within two weeks. The upside of shorter terms is that even late payments are received more quickly. So if cash is a serious concern, make sure that you first understand your customers’ expectations and then consider tightening up payment due dates.
DSO and the Cash Conversion Cycle
Days sales outstanding plays a large role in the cash conversion cycle (CCC), another metric business owners might choose to track closely. The cash conversion cycle shows how long it takes for every dollar invested into the business to emerge as cash from the customer. In other words, CCC takes into account how long it takes to produce and sell inventory, collect on sales, and pay down accounts payable.
While DSO helps business owners understand their collections processes and may highlight areas of concern within the business, CCC provides a more holistic view of a company’s processes.
At the day’s end, the faster a business is able to sell through inventory and collect payment, the faster they are able to reinvest in growth. A short cash conversion cycle and a short days sales outstanding can propel a business toward faster growth.
In order for days sales outstanding to become a useful management tool for your business, you need to check it often and keep a sharp eye out for changes. This will allow you to stay ahead of any potential issues.
To learn about ScaleFactor’s invoicing tools and dashboard of real-time metrics, speak with an expert today.
Insert your accounts receivable total at the end of the period, as well as your total sales throughout that period, to determine how long it takes to collect payment on average.
On average, it takes your business days to collect payment on outstanding accounts receivables.