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
The days sales outstanding concept has several limitations that you should be aware of. They are as follows:
No allowance for seasonality. DSO can fluctuate seasonally, especially in industries where sales volume varies significantly throughout the year. These seasonal changes can distort the metric, making it harder to assess collection efficiency accurately.
Industry variations. DSO benchmarks vary widely across industries. A "good" DSO for one industry might be high or low for another. Comparing DSO across companies in different industries can therefore be misleading.
Impact of payment terms. DSO can be influenced by the company's payment terms. For example, a company offering a standard 90-day payment term will have a higher DSO than one offering a 30-day term, even if both are equally effective at collecting payments on time.
Masks individual receivables. DSO gives an average of all outstanding receivables, but it doesn’t break down the age of individual accounts. As a result, DSO might mask a few very old receivables that are at risk of non-payment.
Ignores cash sales. DSO only considers credit sales, not cash sales. In businesses where cash sales are significant, DSO alone may not provide a complete view of cash flow efficiency.
Not useful for short periods of time. When DSO is calculated for a very short period, such as a single month, it can be less meaningful because of month-end fluctuations or one-time payments.
Overall, while DSO is a helpful indicator, it’s most useful when used alongside other metrics like the aging schedule, bad debt ratio, or cash conversion cycle for a more comprehensive view of the company’s cash flow health.
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