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What’s it: Days sales outstanding (DSO) is a financial ratio to measure how many days on average it takes the company to collect on accounts receivable. It is inversely related to accounts receivable turnover. Thus, the lower the value, the more favorable it is because it is faster to collect payments from consumers. As a result, the company can use the money to invest in the business. On the other hand, a high DSO indicates a delay in receiving payments, which can lead to cash flow problems.
Examining DSO numbers doesn’t just require us to compare them historically. But, it also requires us to compare similar figures with peer companies or industry averages. Thus, it can reveal meaningful information.
Why are days sales outstanding important?
DSO is important because it provides insight into how a company manages its credit sales. The higher the DSO, the more money tied to the customer. Companies have to face an increased risk of default as it takes longer to get paid. Then, the longer the company can accumulate it, the less cash inflows will be available, disrupting the liquidity where companies have to pay some of their short-term bills.
An increase in DSO signals something is wrong. The company may give too lenient credit compared to its competitors. Poor invoice management is another culprit.
Alternatively, the increase may occur because customer satisfaction decreases and is reluctant to fulfill its obligations on time. Or, it’s because more sales come from poor quality customers who have bad credit and are still allowed to buy on credit.
Another reason for the rise in DSO is the challenging market conditions. As a result, many customers struggle to pay their bills on time.
To address such problems, companies seek to collect unpaid receivables as quickly as possible, which can be by improving existing credit and collection policies or providing incentives to customers for early payments. Another alternative is to sell invoices to factor companies to get cash early.
How to calculate days sales outstanding and read the results?
To calculate days sales outstanding, we need two numbers: accounts receivable and sales on credit. We can find accounts receivable on the balance sheet, namely in the current assets section. Meanwhile, some analysts use sales/revenue figures in the income statement as an alternative to selling on credit. Then, we calculate it with the formula below:
- Days sales outstanding = 365 / Accounts receivable turnover
- Days sales outstanding = 365 * Average accounts receivable / Sales on credit
Remember, the number 365 represents the number of days in a year. Some analysts might use 360 instead of 365. Alternatively, we use the normal number of business operating days in a year.
Now take a simple example. A company has annual revenues of $1,000,000. On its balance sheet, the average trade receivables for the last two years is $10,000. Applying the above formula, we get DSO equal to 3.65 = 365 * 10,000/1,000,000.
How to read it?
The formula above shows us the accounts receivable turnover ratio is inversely proportional to DSO. The higher the receivable turnover, the lower the DSO and the better. For example, a DSO of 30 means that, on average, it takes the company 60 days to collect payments from customers.
A lower DSO indicates the company is waiting shorter to collect money from sales on credit to customers. Companies need fewer days to collect receivables. That increases liquidity because companies can reuse their money to pay bills, buy inventory, or pay off debt.
Conversely, a high DSO indicates getting longer payouts. As a result, less cash is collected, which can lead to cash flow problems.
Special note
We need to remember to calculate the above DSO we use credit sales. Some people may use sales figures on the income statement because they are practical. However, it can give a biased picture.
For example, two companies have different proportions of credit sales. The company ABC has a low proportion of credit sales, and most of its sales are cash. In contrast, the company XYZ has a higher proportion of credit sales than cash sales.
Despite operating in the same industry, comparing the two DSOs using total sales figures is less informative. If we take cash sales into account, it will lower the DSO. Thus, the company ABC will have a low DSO. We might then conclude that the company ABC is better at collecting receivables than the company XYZ.
This conclusion could be wrong if we only consider credit sales in the DSO calculation. We may come to different conclusions. That’s because if we include cash sales, it inflates the DSO figure we get, which treats the money from cash sales as if it were the same as money billed from credit sales to customers.
