Days sales outstanding is one of the most important metrics managers use to determine the health of their accounts receivables departments. To accomplish this, managers specifically look at the DSO ratio. This information helps accountants determine how to adjust their accounts receivables strategies to ensure they bring in enough cash flow to cover all financial obligations.
Understanding Days Sales Outstanding
In its simplest form, days sales outstanding shows the average number of days it takes a business to convert a sale into cash. Managers usually calculate DSO on a timed schedule, such as annually, quarterly or monthly. This is why it’s such an excellent telltale sign that a company is practicing healthy credit management tactics and collection measures.
Sometimes, people confuse this with receivables turnover. While this may also measure the performance of the accounts receivable department, it does so differently. When comparing receivables turnover vs. DSO, keep in mind DSO calculates the average length of days it takes to collect the full balance owed. Receivables turnover calculates how often the business collects the average amount of money owed.
What Is the Formula for Days Sales Outstanding?
Learning how to calculate DSO is fairly easy. It involves dividing the accounts receivable by the net credit sales then multiplying that by the number of days. Because of this formula, it is also sometimes referred to as “days sales in receivables.”
To better illustrate how the formula works, consider this days sales outstanding example:
John is a beekeeper. He sells honey to several bakeries and food processing plants within a 100-mile radius. He has current accounts receivable of $2,000 and total accounts receivable of $200,000. Within a 30-day period of credit payments, he brings in $150,000.
To calculate the DSO, we divide his total $200,000 AR by his net credit sales of $150,000. This amounts to 1.33. We then multiply this by 30, which amounts to 40 days.
Why Is DSO Important?
When companies pay close attention to DSO, they can determine more than their cash flow health. They can also determine which customers are more likely to struggle with payments and then dig deeper to identify shared factors. This can also prove useful in helping the company predict and plan for its own cash crisis, if necessary. Most importantly, a company can use DSO to determine how well accounts receivables or collections department is performing.
How To Improve DSO
The good news is there are a wealth of options available for companies to improve their DSO ratios. These are the most effective tactics that have worked well across industries:
Calculate Customer Risk
The best way to reduce the risk of customers not paying on time is not to provide credit to those customers. This is more easily said than done, but with time and experience, companies can become better at determining high-risk customers. Finance professionals at the company can then determine the credit limit for those customers or decide if they should receive any credit at all. This could save the finance team thousands of dollars in man-hours and unpaid debt.
Have you ever noticed the discount you receive for paying for monthly services in bi-annual or annual bulks? Excellent examples include your car insurance or even online retailer memberships. Business clients generally respond favorably to receiving the same incentives to pay early or in full. Try to focus on positive reinforcement; highlighting a discount for early payment in place of a penalty for not doing so.
Provide Payment Flexibility
How many ways can a company settle its bill with your company? The more options, the easier it is to pay. The easier it is to pay, the more likely it is that you will receive your money on time. Payment flexibility most commonly speaks to specific methods, such as cash, credit, check or online payments. However, it can also refer to options to make partial payments throughout the payment period.
Automating the real-time calculation of DSO can also save companies a lot of time and money. Some accounting software can assist with the collections process by creating premade templates or prompts to encourage customers to pay. This, in turn, frees up the accounting team to focus on other important aspects of a company’s finances.
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