In an ideal world, all customers would pay an invoice the moment they receive it. But in reality, companies often have to spend considerable time and resources chasing down late payments that are stuck in Accounts Receivable.
Promptly collecting payments from your customers is essential to run a sustainable business. Over time, late payments have a detrimental effect on cash flow and company resources, especially if you need to get outside creditors involved. In fact, 81% of large retailers say that real-time payments are critical to their operations.
DSO, or Days Sales Outstanding, is a formula and KPI for small and medium-sized businesses to measure the average number of days it takes to collect payments from customers. As well as identifying inefficiencies in payment processing or customer communications, DSO is a key financial benchmark to assess liquidity and the state of accounts receivable.
In this blog, we’re going to explore the importance of DSO, how to calculate it, and strategies to help improve DSO to create a healthier business.
TL;DR
- DSO is calculated by dividing Net Credit Sales by Accounts Receivable, then multiplying by the number of days in any given period.
- DSO is influenced by a range of factors, including a company’s credit policy, customer purchasing patterns, and invoice management.
- Implementing stricter credit policies, automated invoicing, and better customer relationship management lead to more efficient account receivables management and improved DSO.
What is Days Sales Outstanding?
DSO means Days Sales Outstanding and is a metric for measuring the average number of days it takes for a business to collect payment after products or services are rendered. The faster that credit sales are collected, the faster it can be reinvested into your business to attract more customers.
Because businesses collect the proceeds from cash sales immediately, DSO calculations are only used to measure credit sales, which may be realized over weeks or months, depending on the payment terms.
Measuring DSO ratio helps businesses understand when they can expect to receive payment and whether there’s an imminent risk to cash flow. A low DSO value means a business is collecting payments quickly and efficiently, meaning more robust working capital and a streamlined cash conversion cycle.
A high DSO may indicate that a business does not have a robust collection process in place, which is resulting in delays to receiving customer payments. In addition to reducing profitability and increasing days payable outstanding (DPO), high DSO can seriously hinder business growth – especially if your total credit sales make up a large proportion of overall sales.
How to Calculate DSO: Days Sales Outstanding Formula
The standard DSO formula is as follows:
Days Sales Outstanding (DSO)= Net Credit Sales / Accounts Receivable)× X Number of Days in the Period
Let’s break this down:
1. Define the time period
First, you need to decide what period of time you want to calculate DSO for. This could be monthly, quarterly, or annually, depending on your needs.
2. Divide Total Accounts Receivable by Net Credit Sales
Your Net Credit Sales should be recorded after any discounts or returns have been taken into account. Accounts Receivable is the total figure at the end of the time period chosen.
3. Multiply by the exact number of days in your chosen period
Let’s say you wanted to understand the average DSO for the entire month of April. If your Total Accounts Receivable was $80,000 at the end of April while total Net Credit Sales were $35,000, dividing Accounts Receivable by Net Credit Sales would be represented like this:
$80,000 / $35,000 = 2.28
Multiplying this figure by the total number of days in April (30 days) gives us your company’s DSO for the whole month:
2.28 x 30 = 68.4
In this example, it takes 68 days on average in this example for your business to collect payment for credit sales.
Factors Influencing DSO
Credit policies
The credit policy decided by a business has a big influence on DSO, as more lenient policies—such as longer payment terms or a lack of credit checks – will likely result in later payments by customers, which in turn pushes up DSO. Taking a more conservative approach to credit sales, by only making them available with stricter terms or to existing customers with a good payment history, help keep DSO under control.
Customer payment behaviors
How quickly or slowly your customers make payments has a direct impact on DSO, as timely payments by the due date keep DSO low. If payments are consistently collected late or after multiple reminders, this lengthens DSO and requires more company resources to secure payments, which can impact customer satisfaction as well as company finances.
The impact of economic conditions on DSO
When economic conditions are unpredictable or less favorable for businesses, this can result in increased DSO as businesses prolong paying what they owe to preserve cash flow. When interest rates are high, companies may have a less liquidity due to paying bigger loans or having difficulty securing lending, which has a knock-on effect on vendors.
Strategies for Improving DSO
Implementing stricter credit policies
Taking a more conservative approach to which customers are eligible for credit sales is a good way to lower DSO and minimize delayed payments.
For example, you could decide that credit is only offered to existing customers who have a track record of on-time payments, or reward customers who make early payments with incentives such as discounts. If you want new customers to have access to credit, it’s worth implementing credit checks to determine whether they’re an appropriate fit for credit sales. It’s a good idea to use a standardized approach and request information such as financial statements when new customers are onboarded.
Enhancing invoice management processes
Invoice management plays a pivotal role in avoiding late payments. This includes schedules, templates, and follow-up reminders for outstanding invoices – something which is difficult to do with just an excel spreadsheet. All invoices should clearly state when payments are due, what payment methods are available, and any penalties that will be levied on unpaid invoices. This helps to streamline the payment process and remove friction on the customer’s end.
Automation of invoice workflows is a great way to free up staff time and avoid unnecessary delays to payment collection. For example, automating the sending of invoices helps reduce your days sales outstanding by ensuring that invoices don’t require manual send-offs that could be delayed by holidays or staff sickness.
Fostering better customer relationships to improve payment times
Building better trust and communication with your customers helps to nip payment issues in the bud by setting clear expectations and boundaries in the business relationship. It’s important to address payment and credit terms ahead of time and give your customer a chance to raise any concerns or questions before invoices are due. This also provides opportunities to amend payment terms with full agreement from both parties, such as alternative payment methods, a different time frame for due dates, or certain services being paid for upfront.
Leveraging technology for efficient receivables management
Improving your overall process for managing the Accounts Receivable process makes it far easier to get a handle on your company’s accounts and what is being entered on the balance sheet. In addition to automating the sending and follow-up of invoices, tools like recurring billing, online payment portals, and receivables tracking minimize the amount of time your business needs to spend chasing up payments or understanding how many payments are left to collect.
Case in point: Stax Bill, a recurring billing and subscription management platform that automates payments. Stax Bill simplifies your processes, enabling you to work more efficiently, recover revenue, and collect on invoices.
Some platforms enable you to track DSO directly and identify trends like seasonality or whether different industries are more liable to higher DSO than others.
The Limitations of DSO
Although useful, there are a lot of reasons why DSO doesn’t provide businesses with a clear financial picture, such as:
Credit terms differ between businesses
Different companies will offer their customers different credit policies, depending on the industry, the length of the customer relationship, and the size of the sale. More generous credit terms can cause higher DSO, as customers may take longer to make payments, resulting in a higher average accounts receivable balance. However, this doesn’t necessarily mean a business has been lax with collecting payments, or that a company’s cash flow is adversely affected.
Seasonal variations in DSO
For the majority of businesses, consumer spending patterns are not uniform throughout the year; instead, there are peaks and troughs that align with key events or seasons. Retail companies typically see the biggest spike in sales and DSO during the holiday season, which is also when many consumers use credit to make purchases. These kinds of seasonal variations mean it’s a good idea to exclude time periods like the holiday season when tracking DSO, as this may skew financial ratios.
Different industries see different DSO numbers
Some industries are more prone to high DSO than others, which can result in a distorted impression of what is considered a good Days Sales Outstanding ratio. For example, industries such as construction, healthcare, and manufacturing typically see longer payment cycles due to having long project timelines and additional steps like reimbursements, billing approvals, and progress payments that push up DSO. In these cases, DSO doesn’t necessarily equate to cash flow problems, as companies in these industries typically set pricing or invoice schedules accordingly.
Example of Successfully Managing DSO
The healthcare industry is one of the most adversely affected by DSO, due to the difficulty in collecting payments from insurers in a timely manner.
Long processing times for even minor insurance claims result in DSO timeframes ballooning, with the average DSO from healthcare providers reaching 47 days, according to the Working Capital Tracker study.
Furthermore, 37% of healthcare providers reported being owed amounts ranging from $25,000 – $100,000, while another 32% reported amounts exceeding $100,000.
Given that healthcare providers rely on timely claim resolutions to release funds, automation and predictive analytics have proven to be useful methods in reducing DSO. Automation allows for simpler medical claims to be either approved or denied in a much faster timeframe, while overdue invoices can be flagged for further action much more quickly than via a manual approach. For this reason, 52% of surveyed healthcare providers reported having replaced previous claims processing technology with automated systems in the past year, which will go a long way towards reducing DSO.
Final words
Tracking your Days Sales Outstanding (DSO) is one of the best ways to manage the overall financial health of your business. A low DSO is a good sign that your business is collecting payments from customers promptly and keeping Accounts Receivable under control. High DSO, however, is a strong indicator that your business is struggling to collect payments in a timely manner and may be at risk of struggling with cash flow.
DSO can be more effectively controlled by implementing stricter credit policies, implementing automation for invoice management, and fostering better relationships with customers. However, DSO does have some limitations, such as industry variations and seasonal fluctuations, which can make it difficult to assess DSO and make accurate comparisons between businesses.
In sum, by prioritizing DSO and accounts receivable management, businesses can set themselves up for better resilience during tough challenging economic times and spend less time and resources chasing up payments. This means more bandwidth for initiatives that grow your business and achieve better long-term success.
Payment processing can go a long way in ensuring you’re able to collect payments efficiently. That’s why it’s important to partner with a payment processing company that offers quick payouts—like Stax.
Request a QuoteQuick FAQs about Days Sales Outstanding
Q: What is Days Sales Outstanding (DSO)?
DSO stands for Days Sales Outstanding, it’s a key financial benchmark and an important metric for measuring the average number of days it takes for a business to collect payment after products or services are sold.
Q: How is DSO calculated?
DSO is calculated using the formula: (Net Credit Sales / Accounts Receivable) × Number of Days in the Period. The first step is to define the time period. Next, divide Total Accounts Receivable by Net Credit Sales for that period. Lastly, multiply by the exact number of days in your chosen period.
Q: What does a low DSO value indicate?
A low DSO value indicates that a business is collecting payments quickly and efficiently, resulting in more robust working capital and a streamlined cash conversion cycle.
Q: What does a high DSO suggest?
A high DSO may suggest that a business doesn’t have a robust collection process in place, leading to delays in receiving customer payments. This can reduce profitability, increase days payable outstanding (DPO), and hinder business growth.
Q: What factors influence DSO?
DSO is influenced by various factors such as a company’s credit policy, customer purchasing patterns, economic conditions, and invoice management processes.
Q: Are there strategies to improve DSO?
Yes, strategies to improve DSO include implementing stricter credit policies, enhancing invoice management processes, fostering better customer relationships, and leveraging technology for efficient receivables management.
Q: How does DSO impact a company’s financial health?
DSO gives an indication of the state of a company’s accounts receivable and its liquidity. A lower DSO implies a healthier business as it indicates that the company is able to collect its due payments faster.
Q: Are there limitations to DSO as a metric?
Yes, DSO has several limitations, such as differences in credit terms between businesses, seasonal variations, and industry-specific trends, which can affect the accuracy of DSO as a financial indicator.
Q: Can technology help in improving DSO?
Yes, technology can significantly improve DSO. Automation tools for invoice management, recurring billing, online payment portals, and receivables tracking can enhance efficiency and minimize the time spent on chasing up payments.
Q: What is an example of a sector with a high DSO?
The healthcare industry typically has a high DSO due to the complexity and duration of the payment process, especially in collecting payments from insurers.
