What is 'Days Sales Outstanding - DSO'
Days sales outstanding (DSO) is a measure of the average number of days that a company takes to collect revenue after a sale has been made. DSO is often determined on a monthly, quarterly or annual basis and can be calculated by dividing the amount of accounts receivable during a given period by the total value of credit sales during the same period, and multiplying the result by the number of days in the period measured.
The formula for calculating days sales outstanding can be represented with the following formula:
A low DSO value means that it takes a company fewer days to collect its accounts receivable. A high DSO number shows that a company is selling its product to customers on credit and taking longer to collect money.
Days sales outstanding is also often referred to as “days receivables” and is an element of the cash conversion cycle.
BREAKING DOWN 'Days Sales Outstanding - DSO'
Due to the high importance of cash in running a business, it is in a company's best interest to collect outstanding receivables as quickly as possible. While companies can most often expect with relative certainty that they will in fact receive outstanding receivables, because of the time value of money principle, money that a company spends time waiting to receive is money lost. By quickly turning sales into cash, a company has a chance to put the cash to use again more quickly. Ideally, the company will use it to reinvest and thereby generate more sales. A high DSO value may lead to cash flow problems because of the long duration between the time of a sale and the time the company receives payment. In this respect, the ability to determine the average length of time that a company’s outstanding balances are carried in receivables can in some cases tell a great deal about the nature of the company’s cash flow.
For example, suppose that during the month of July, Company A made a total of $500,000 in credit sales and had $350,000 in accounts receivable. There are 31 days in July, so Company A’s DSO for July can be calculated as:
($350,000 / $500,000) x 31 = 0.7 x 31 = 21.7
With a DSO of 21.7, Company has a very short average turnaround in converting its receivables into cash. Generally speaking, a DSO under 45 is considered low; however, what qualifies as a high or low DSO may often vary depending on business type and structure. For example, a DSO of 40 may still cause cash flow problems for a small or new business that has little available capital. Because of the lower earnings that often accompany small or new businesses, such businesses often rely on obtaining their accounts receivable quickly in order to cover startup costs, wages, overhead and other expenses. If they cannot collect payments quickly enough, they may struggle to meet these costs. On the other hand, a DSO of 60 may cause few issues for a large and well-established corporation with high available capital. Though the company could likely improve its earnings by reducing its DSO and thereby maximize its potential to reinvest earnings, it is unlikely that the company will need to trim salaries or cut other costs in order to make ends meet.
Generally, a high DSO can suggest a few things, including that the company’s customer base has credit issues or that the company is deficient in its collection processes. Conversely, a very low DSO ratio may suggest that the company is too strict with regard to its credit policy, which could alienate customers and thus hurt sales as well.
It is important to remember that the formula for calculating DSO only accounts for credit sales. While cash sales may be considered to have a DSO of 0, they are not factored into DSO calculations because they represent no time between a sale and the company’s receipt of payment. If they were factored into DSO, they would decrease DSO values and companies with a high proportion of cash sales would have lower DSOs than those with a high proportion of credit sales.
Uses of 'Days Sales Outstanding - DSO'
Days sales outstanding has a wide variety of applications. It can indicate the amount of sales a company has made during a specific time period, how quickly customers are paying, if the company’s collections department is working well, if the company is maintaining customer satisfaction or if credit is being given to customers that are not credit worthy.
While looking at an individual DSO value for a company can provide a good benchmark for quickly assessing a company’s cash flow, trends in DSO are much more useful than an individual DSO value. If a company’s DSO is increasing, it may indicate a few things. It may be that customers are taking more time to pay their expenses, suggesting either that customer satisfaction is declining, that salespeople within the company are offering longer terms of payment to drive increased sales or that the company is allowing customers with poor credit to make purchases. Additionally, too sharp of an increase in DSO can cause a company serious cash flow problems. If a company is accustomed to paying its expenses at a certain rate on the basis of consistent payments on its accounts receivable, a sharp rise in DSO can disrupt this flow and force the company to make drastic changes.
Generally, when looking at a given company’s cash flow, it is helpful to track that company’s DSO over time to determine if its DSO is trending in any particular direction or if there are any patterns in the company’s cash flow history. DSO may often vary on a monthly basis, particularly if the company is affected by seasonality. If a company has a volatile DSO, this may be cause for concern, but if a company’s DSO dips during a particular season each year, this is often less of a reason to worry.
Limitations of 'Days Sales Outstanding - DSO'
Most simply, when using DSO to compare the cash flows of multiple companies, one should compare companies within the same industry, ideally when they have similar business models and revenue numbers as well. As mentioned above, companies of different size often have very different capital structures, which can greatly influence DSO calculations, and the same is often true of companies in different industries. DSO is not particularly useful in comparing companies with significant differences in the proportion of sales that are credit, as determining the DSO of a company with a low proportion of credit sales does not indicate much about that company’s cash flow. Comparing such companies with those that have a high proportion of credit sales also does not usually indicate much of importance.
Furthermore, DSO is not a perfect indicator of a company’s accounts receivable efficiency, as fluctuating sales volumes can affect DSO, with increase sales frequently lowering the DSO value. DDSO is a good alternative for credit collection assessment for use alongside DSO. Like any metric measuring a company’s performance, DSO should not be considered alone, but instead should be considered with other metrics as well.
For more on DSO and how to lower it, read Understanding The Cash Conversion Cycle.