Understanding Days Sales Outstanding (DSO)
Businesses have been providing ease of payment for customers. As a result, the customers can make purchases using cash, debit cards and even credit cards. While the transactions seem simpler with these cards for the end-users, the business owners need to manage the days sales outstanding for the credit cards.
In this blog, you are going to read about -
- What is meant by Days sales outstanding?
- Why is it important?
- How to use it in business?
- What are its applications?
- Good and Bad DSO numbers
- What are the methods to lower days sales outstanding
- How to do DSO calculation
What is meant by Days sales outstanding?
Days sales outstanding or DSO is a term used for the companies. It is defined as the measure of the average number of days that an organization takes to collect the payment for a sale done. The calculation of DSO by the business owner on the following basis-
- Monthly
- Quarterly
- Annual
This is the count of how many days a small business owner takes to collect the account receivables. For a given period, DSO is calculated as -
Days sales outstanding = (Avg. Accounts receivable ÷ Annual revenue) × Number of days in a year
Here, the number of days is usually counted for a year; that means 365 days. Hence, the formula can also be given as -
According to the statistics, if the DSO is low it indicates that a business requires a few days to collect the account receivables. However, if it is the opposite and the calculated DSO turns out to be high then the business takes many days to collect the receivables. It also implies that it could even lead to certain cash flow issues for the businessman. This is one of the basic and primary metrics used by a businessman to calculate his organization’s cash flow cycle.
Why is it important?
Days sales outstanding is considered to be an important factor by the entrepreneurs for their business. It is used to understand the success factor of a business. Hence, according to established experts, a low DSO is always preferred compared to a high DSO. Let us know the reason behind this -
- A low days sales outstanding indicates that the organization converts credit sales into cash faster. It means that the duration for account receivables to remain outstanding on the balance sheet before the business collection is done is found to be shorter.
- However, if the company has a high DSO, it means the organization is not able to convert the credit sales into cash faster. This indicates the company has less liquidity as the receivables remain outstanding for a longer time.
The days sales outstanding value is considered to be important for an organization as it denotes the operating efficiency of the firm. As stated in the above bullet points, a low DSO means a good DSO. It indicates that the organization has increased liquidity which is more cash in its accounts. This gives the business owner more free cash flows (FCFs) which could be reallocated for various business purposes.
How to use it in Business?
A small business owner or even a big entrepreneur can use the days sales outstanding measurement monthly. When there is an accurate monthly record of DSO, the businessman can understand if there have been any changes in the HR department’s ability in collecting the payments.
If the businessman has seasonal business and has sales only during those specific times, then the business owner can use variation to know the efficiency. A variation means the entrepreneur has to compare the DOS measurement to the same metric and for the same month in the previous year to the current year. Doing so provides a more reasonable basis for the entrepreneur for comparison.
Irrespective of the method used for days sales outstanding measurement, a business owner must keep in mind that this calculation is generally compiled by using a large number of outstanding invoices for some time. It offers no insights for a specific invoice. Hence, the industrialist must support the concerned DOS with an ongoing examination of the accounts receivable report along with the collection notes from the office staff. If a business owner wants to acquire a new business segment or add something innovative to his existing business, DSO is a highly useful measurement.
An entrepreneur can use days sales outstanding to acquire small business owners’ firms to improve the credit and collection activities for his company. If the industrialist uses this acquisition technique, then he can reduce the working capital of the acquired company which indirectly reduces the amount of initial acquisition cost.
What are its Applications?
Business owners can use days sales outstanding analysis in several ways. It not only gives accuracy to the efficiency of the firm but also is considered to be a major factor in maintaining customer satisfaction. The sales department of the organization can keep a customer database to identify which customers are not creditworthy and hence, make sure that they pay using cash or debit card instead of taking credits for the purchase.
Moreover, as per the available information, this DSO value for a single period can give a fair idea about the company’s cash flow for the transactions. According to the available data, an organization must use the days sales outstanding report for multiple years as these are found to be more useful for deciding on a good benchmark instead of a single year. Also, it can give a warning sign or indicate trouble for the business owner which will make him take appropriate steps to streamline his business before there is a major loss.
Good and Bad DSO numbers
According to experts, if the days sales outstanding are increasing for an organization it indicates there is something wrong in the business. The reason for bad DSO could be
- Declining customer satisfaction
- Sales managers or employees in the sales department are given a longer duration for payment to drive increased sales.
- The organization permits customers who have poor credit to continue with purchases on their respective credit cards.
A rise in the days sales outstanding can be the cause of serious cash flow problems in an organization. Also, if the firm's ability to make its payments in a timely manner is suddenly disrupted then it may be compelled to enforce drastic changes. This can include coercing the employees to put in the papers and even asking the star performers to resign from the company.
Usually, the business owner checks the cash flow of the company to track the status of days sales outstanding. It helps him to understand whether the DSO is trending upwards or downwards and also gives insights into the patterns in the cash flow history of the company. According to the subject-matter experts, this value can vary every month and has a particular effect on the company’s income if the employer’s business is seasonal. Also, these experts say that if the value of a company's DSO is found to be less during a particular season repeatedly for a specific season, the employers must not worry about it.
What are the methods to lower Days Sales Outstanding?
The business owners can use any one of the following tactics to lower the days sales outstanding for the organization and gain good profits in business. The businessman can use the after comparison with other companies in his industry to arrive at a sound decision. Some of the methods to lower the DSO are -
- Minimise use of credit cards - Declining payments are done via credit card
- Provide incentives on cash - Offering attractive discounts to customers for cash pay
- Identification of delayed payments - The small business owner can also have a list of customers who have a repeated history of delayed payments and even place certain restrictions on them. This can force the purchasers to buy the product with upfront cash payments
- Do a verification for credit background checks - The business owners can even perform a check on the credit card payments of a customer before allowing him to do the transaction with the card. It helps the accounting and sales team understand his history of credits and even gives flexibility to the business owner to install relevant payment agreements.
However, in some scenarios, there could be buyer power and negotiable leverage. This is the case where the extended DSOs are allowed as it functions because the customer payments are considered to be a significant revenue source for the business owner. As the business is partially dependent on the customers, the industrialist has to push back their payment dates to survive in the business world. As a result, sometimes to maintain a good customer-buyer relationship, the entrepreneurs have to let go of the constant effort to match with their peers. This can be done when the relationship with the customers is long-term and has become trustworthy over the period.
How to do DSO calculation?
If you are an entrepreneur who is doing the days sales outstanding calculations for the first time as the business is in the start-up phase, then you should use a readily available Excel sheet to avoid miscalculations.
A good accounting department can get the business owner an accurate DSO report each year. Check the image below to understand how to calculate it using the above-given formula -
The only limitation of days sales outstanding is that even if the entrepreneur uses the competitors' tactics to get a good DSO figure, it varies from business to business and is also dependent on the strategies a business owner wants to have for his organization.
Conclusion
To know where the business stands, a business owner has to do a periodic days sales outstanding. It can help him understand his customers and classify them according to their credit payments. The days sale outstanding also gives a fair idea about the performance of a business and overall income. It helps the entrepreneur decide his next steps and even put limitations for the customers as needed. Deskera is advanced and technological accounting software that can help business owners maintain appropriate sales and bookkeeping records for business growth.
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Key Takeaways
- Every business owner must keep an accurate calculation for days sales outstanding to review the performance of his business.
- This can be calculated on a monthly, quarterly or even yearly basis. Usually, the formula of DSO calculates it for a year.
- Days sales outstanding = (Avg. Accounts receivable ÷ Annual revenue) × 365
- A low value means there is good cash flow in the organization and it is successful in converting the credits into cash in a short time. On the other hand, if a company has a high DSO value, then it takes a longer time to receive credits and has poor liquidity.
- A bad days sales outstanding could be because of declining customer satisfaction, permission by the company for a longer duration to clear payments or allowing customers with bad credits to shop without any restrictions.
- The businessman can reduce his high days sales outstanding by rules such as reduced use of credit cards for the buyers, extra beneficiary incentives for customers paying with cash and even doing a background check for customer payments to know what is their credit card status