Days Sales Outstanding (DSO) is the average number of days taken by a firm to collect payment from their customers after the completion of a sale. As a business owner, you can also view DSO as the number of days it takes for credit sales to be converted to cash, or the number of days that receivables remain outstanding until they’re collected.
What is Days Sales Outstanding (DSO)?
Days Sales Outstanding (DSO) represents the average number of days it takes credit sales to be converted into cash or how long it takes a company to collect its account receivables. DSO can be calculated by dividing the total accounts receivable during a certain time frame by the total net credit sales. This number is then multiplied by the number of days in the period of time.
The period of time used to measure DSO can be monthly, quarterly, or annually. If the result is a low DSO, it means that the business takes a few days to collect its receivables. On the other hand, a high DSO means it takes more days to collect receivables. A high DSO may lead to cash flow problems in the long run. DSO is one of the three primary metrics used to calculate a company’s cash conversion cycle.
What is the Formula for Days Sales Outstanding?
To determine how many days it takes, on average, for a company’s accounts receivable to be realized as cash, the following formula is used:
DSO = Accounts Receivables / Net Credit Sales X Number of Days
Example Calculation-George Michael International Limited reported a sales revenue for November 2016 amounting to $2.5 million, out of which $1.5 million are credit sales, and the remaining $1 million is cash sales. The accounts receivable balance as of month-end closing is $800,000.
Given the above data, the DSO totaled 16, meaning it takes an average of 16 days before receivables are collected. Generally, a DSO below 45 is considered low, but what qualifies as high or low also depends on the type of business. Different industries have markedly different average DSOs. Also, cash sales are not included in the computation because they are considered a zero DSO – representing no time waiting from the sale date to receipt of cash.
What are the Indications of a High or Low DSO?
A high DSO value illustrates a company is experiencing a hard time when converting credit sales to cash. But, depending on the type of business and the financial structure it maintains, a company with a large capitalization may not view a DSO of 60 as a serious issue.
However, for a small-scale business, a high DSO is a concerning matter because it may cause cash flow problems. Smaller businesses typically rely on the quick collection of receivables to make payments for operational expenses, such as salaries, utilities, and other inherent expenses. They may struggle for cash to pay these expenses from time to time if the DSO continues to be at a high value.
To solve high DSO issues, a company must determine what factors are affecting sales and collection. The situation may suggest the following various reasons:
- Credit issues with customers with a negative credit standing
- Sales teams are offering longer payment terms for customers to pump up sales
- Company is encouraging customers to purchase on credit, so they buy more products and services
- Company is inefficient or ineffective in its collection process
On the other hand, a low DSO is more favorable to a company’s collection process. Customers are either paying on time to avail of discounts, or the company is very strict on its credit policy, which may negatively affect sales performance. However, having a low DSO for small to medium-sized businesses generally carries considerable benefits. Fast credit collectability decreases problems related to paying operational expenses, and any excess money that is collected can be reinvested right away to increase future earnings.
FAQS
What is Days Sales Outstanding (DSO)?
Days Sales Outstanding (DSO) is a financial metric that measures the average number of days it takes a company to collect payment from its customers for credit sales. It indicates the effectiveness of a company’s accounts receivable management and its ability to convert credit sales into cash.
Why is DSO important?
DSO is important because it provides insights into a company’s cash flow management, liquidity, and overall financial health. It helps identify trends in customer payment behavior, assess the effectiveness of credit policies, and identify potential areas for improvement in accounts receivable management.
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