Days sales outstanding (DSO) is the average number of days that receivables remain outstanding before cash is collected. This number shows the speed of cash flow, and provides an indicator of the efficiency and profitability of the business.
The calculation for DSO is:
(Accounts receivable ÷ Annual revenue) × Number of days in the year
For example, let’s say we have a retail business with $70,000 in their AR balance sheet, and an annual revenue of $1,000,000. The formula would be:
($70,000 / 1,000,000) x 365 = 25.5 days for DSO
This tells us that it typically takes that retail business 25 days to collect cash for its invoices.
Why track DSO?
DSO is a metric CFOs and CEOs will look at to evaluate if the company's credit and collection efforts are effective. On an overall level, it shows how quickly a company can reinvest cash into its own business for continued sales and potential growth. Following DSO trends for the business over time, executives can see if the business is becoming more or less efficient over time, if credit or collections policies need to be adjusted, or how economic conditions are impacting the health of the business.
AR teams also use DSO, not just for broader business trends, but also at the individual customer level. Tracking this allows them to see if a customer is experiencing cash flow issues that might impact the business and the relationship overall. This might lead to changes in credit and payment terms extended to individual customers, and how AR teams choose to segment customers for such terms.
What’s a “good” DSO number?
There is not a single DSO number that represents excellent or poor accounts receivable management, since this number varies considerably by industry and by the underlying payment terms. On average, any number below 40 is typically considered a “good” number. But if we look at different industries, recent numbers suggest that in the pharmaceuticals space, DSO is 62 days whereas in textiles, apparel and footwear it’s 98 days, and in grocery and specialty retail, it’s only 7 days. So clearly, business models and payment options matter.
Generally speaking, however, a lower ratio is more favorable because it means companies collect cash earlier from customers and can use this cash for other operations. It also shows that the accounts receivables are good and won’t be written off as bad debts.
A higher ratio may indicate a company with poor collection procedures and customers who are unable or unwilling to pay for their purchases. Companies with high days sales ratios are unable to convert sales into cash as quickly as firms with lower ratios.
Challenges with DSO
DSO has its place in providing an overview to business health and processes. However, there are some issues with the metric to keep in mind, as it’s not always the best number to represent business efficiency or profitability.
- Seasonality: DSO is a linear metric, meaning it uses numbers over time against a total. It’s the law of averages. However, in seasonal industries, it’s best to compare prior year’s months or quarters with current year’s to accommodate the dips and bumps in cash flow. Think about businesses heavily reliant on summer tourist seasons, or special retailers whose revenues spike in line with specific holidays.
- Sales complexity: While DSO can be a leading indicator,the complexity of the business’ sales offers, the types of promotions being run and the credit being extended all impact gross revenue, which is part of the equation. However, complex credit terms or an influx of high-risk customers due to a marketing promotion, can skew the real picture of what’s happening with your business.
These challenges can be addressed with calculated adjustments, which means DSO can still be a valuable “weathervane” metric for any business that gives it some thought.