Day sales outstanding, ‘DSO’ for short, can improve visibility into your company’s accounts receivable. This will help manage expectations around payment times and ultimately improve the efficiency of your payment collection systems. Keep reading for our short guide to how DSO works, the day sales outstanding formula, examples, why the calculation is important, and how to reduce your company's DSO.
What does Days Sales Outstanding (DSO) mean?
Day sales outstanding refers to the average number of days your business takes to collect payment after selling a product or service. If your business has a high DSO, this indicates your business takes a long time to collect payment for outstanding invoices. If your DSO is low, on the other hand, this indicates your payment collection is running efficiently. Usually, a DSO under 45 would be considered low. However, this varies slightly, depending on the industry.
Days Sales Outstanding Formula
The formula for day sales outstanding is as follows: DSO = (Accounts Receivables / Net Credit Sales) x Number of Days.
The different elements of a DSO calculation are:
- Accounts receivable = outstanding payments to be collected
- Net credit sales = credit sales made on top of accounts receivable
- Number of days = number of days in the month in question
Days Sales Outstanding Calculation Examples
Company X reports GPB 420,000 of credit sales in October. Additionally, they report GPB 85,000 of accounts receivable to be collected from clients. October has 31 days.
The day sales outstanding formula would look as follows: DSO = (85,000/420,000) x 31 = c. 6.
Company Y reports GPB 220,000 of credit sales in October. Additionally, they report GPB 340,000 of accounts receivable.
The day sales outstanding formula would look as follows: DSO = (340,000/220,000) x 31 = c. 48.
Company X's DSO is favourable, as it is significantly lower and thereby indicates that Company X's payment collection system works efficiently and will ultimately lead to better financial health.
Company Y's DSO, however, is above 45. This indicates a slightly too high DSO which means their payment collection processes should be improved.
Interpreting day sales outstanding
If your company's DSO is high, this indicates that you are waiting a long time to collect payment from your customers. This is likely to cause cash flow problems. A low DSO, on the other hand, indicates that your business is effiicent in collecting its accounts receivable. Your business is promptly getting the money it needs to create new business.
Why are Days Sales Outstanding important?
Accounts receivables are a cornerstone of your business as they directly impact cash flow. Given the vital importance of cash flow in a business, it is in your best interest to collect your business's outstanding account receivables as quickly as possible. The time value of money principle means that time spent waiting on invoices to be paid is effectively money lost.
Understanding your company's DSO will provide you with an understanding of the efficiency of your payment collection process. Being aware of the average length of time that your company’s outstanding balances are carried in receivables can reveal a lot about the nature of your company’s cash flow. Calculating DSO can also help identify customers that are not creditworthy.
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How to reduce and improve Days Sales Outstanding
- Accurate and timely billing: To ensure a rapid payment collection process, it is crucial to put in place an efficient system for billing customers. Ensure invoices are generated and distributed as soon as possible after goods have been delivered, or services rendered. All the information on the invoice you are issuing should be correct. Inaccurate information leads to invoice queries that then cause payment delays. Ensure you are invoicing the correct customer, for the correct product or services, at the correct price point, and ensure delivery or service location, as well as a valid purchase number, are stated on the invoice.
- Comply with invoicing requirements: It is crucial to adhere to your client's invoicing requirements. This could eg entail checking whether they use purchase order numbers (if they do and your invoice does not refer to a valid purchase number, it is simply not going to get paid). When obtaining a new customer, ensure you collect relevant information on their invoice requirements, including where invoices should be sent, how they should be sent (eg electronically), any addresses required, purchase numbers required, key contacts in case issues arise, and usual payment dates.
- Offer early payment incentives: An alternative to late payment penalties are early payment incentives. You could eg offer discounts if customers pay within the first days.
- Offer incentive not to pay late (e.g penalty): It can be advisable to include late payment penalties (eg fines) in your payment terms. However, this can have a detrimental effect on your relationship with some clients.
- Clear payment terms: Slow payments can be caused by a client's confusion with your payment terms. Be sure that they are clearly and simply stated and set out in a contract that is signed by the client before products or services are provided. Payment terms can also be repeated on each invoice, ideally with a due date.
Limitations of Days Sales Outstanding Calculation
While day sales outstanding can be a useful metric, companies of different sizes and in different industries often have very different DSO benchmarks. Hence DSO is not a very useful metric for comparing the cash flows of companies in different sectors or different sizes.
DSO is also not a perfect indicator of a company’s accounts receivable efficiency as fluctuating sales volumes can affect DSO, with an increase in sales lowering the DSO value.
Also, calculating the DSO on its own does not provide you with a full picture of your company's cash flow. You should always use it in combination with other metrics.
Days Sales Outstanding (DSO) FAQs
- What does DSO stand for in accounting?
DSO stands for day sales outstanding, the average number of days your business takes to collect payment after selling a product or service.
- What is a good Day Sales Outstanding ratio?
If your day sales outstanding are high that means that the company spends more days to collect credit or accounts receivable. In contrast, the low ratio means the company credit policy or collection procedure works very well.
- What is considered a low Days Sales Outstanding number?
If your DSO is low, this indicates your payment collection is running efficiently. Usually, a DSO under 45 would be considered low. However, this differs depending on the industry.