Days sales outstanding calculation
/What is Days Sales Outstanding?
Days sales outstanding (DSO) is the average number of days that receivables remain outstanding before they are collected. It is used to determine the effectiveness of a company's credit and collection efforts in allowing credit to customers, as well as its ability to collect from them. When measured at the individual customer level, it can indicate when a customer is having cash flow troubles, since the customer will attempt to stretch out the amount of time before it pays invoices. The measurement can be used internally to monitor the approximate amount of cash invested in receivables.
There is not an absolute number of days sales outstanding that represents excellent or poor accounts receivable management, since the figure varies considerably by industry and the underlying payment terms. Generally, a figure of 25% more than the standard terms allowed may represent an opportunity for improvement. Conversely, a days sales outstanding figure that is very close to the payment terms granted probably indicates that a company's credit policy is too tight.
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How to Calculate Days Sales Outstanding
The formula for days sales outstanding is to divide accounts receivable by the annual revenue figure and then multiply the result by the number of days in the year. The formula is as follows:
(Accounts receivable ÷ Annual revenue) × Number of days in the year = Days sales outstanding
Example of Days Sales Outstanding
As an example of the DSO calculation, if a company has an average accounts receivable balance of $200,000 and annual sales of $1,200,000, then its DSO figure is:
($200,000 Accounts receivable ÷ $1,200,000 Annual revenue) × 365 Days
= 60.8 Days sales outstanding
The calculation indicates that the company requires 60.8 days to collect a typical invoice.
What is a Good DSO Ratio?
The days sales outstanding figure can vary substantially by industry, since certain credit terms and repayment intervals are expected in some industries that are different in others. Nonetheless, a DSO figure lower than 45 days is generally considered to be a good DSO ratio. At this level, a business probably has creditworthy customers who are paying their invoices within a reasonable period of time.
How to Use Days Sales Outstanding
An effective way to use the days sales outstanding measurement is to track it on a trend line, month by month. Doing so shows any changes in the ability of the organization to collect from its customers. If a business is highly seasonal, a variation is to compare the measurement to the same metric for the same month in the preceding year; this provides a more reasonable basis for comparison.
No matter how this measurement is used, remember that it is usually compiled from a large number of outstanding invoices, and so provides no insights into the collectability of a specific invoice. Thus, it should be supplemented with an ongoing examination of the aged accounts receivable report and the collection notes of the collection staff.
DSO can be a useful measurement for an acquirer. It can look for businesses with unusually high DSO figures, with the intention of acquiring the firms and then improving their credit and collection activities. By doing so, they can strip some working capital out of the acquirees, thereby reducing the amount of the initial acquisition cost.
Limitations of Days Sales Outstanding
When the days sales outstanding figure is employed to compare businesses, keep in mind that the DSO figure can vary by type of business model, which renders these comparisons somewhat less useful. For example, a business that competes by offering loose credit to bring in customers that no one else wants will inevitably have a higher DSO figure than one that uses a tighter credit policy.
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