Days sales outstanding (DSO)
Posted on 24th September 2024 at 14:28
In this blog post from Creditreform you come across a vital financial metric that signals if the company’s collection process is aligned with its daily operations or not.
The metric is called Days Sales Outstanding. You will be reading about its importance, formula for calculation, factors affecting it and why monitoring it matters.
What is It?
Days Sales Outstanding is the average a business takes to collect the payment for the sale made on credit.
Consider it a timer that takes off when a customer buys something and expires when they pay. If the timer ticks fast it indicates that the organisation is efficiently collecting consumer payments; nevertheless, if the timer takes more time, it is a red flag that may indicate upcoming cash troubles.
Formula for Calculation-
DSO = (Accounts Receivable / Total Credit Sales) × Number of days
•Accounts Receivable is the outstanding payments from clients.
• Total Credit Sales refers to the total income generated on credit for a period.
• Number of Days is the time frame (e.g., 30, 90, or 365 days) for the calculation
For example, if a company has $200,000 in receivables and $1,000,000 in credit sales over a 90-day period, the DSO is calculated as ( 200,000 / 1,000,000 )×90 = 18 days.
This indicates that the company takes an average of 18 days to collect payment after a sale.
Factors Influencing DSO
Several things can influence a company's DSO:
1. Industry Standards:
Credit norms usually vary across sectors. For example, the retail sector often has shorter payment cycles than industries such as construction, where long payment terms are common.
2. Credit Policies:
Lenient credit terms can increase DSO as customers take longer to pay, while rigid terms can decrease DSO.
3. Customer Base:
Companies with a few major clients may experience longer DSO due to extended payment terms, whereas a diverse customer base might lower collection times.
4. Economic Conditions:
In weak economy conditions, customers may delay payments, increasing DSO. In contrast, in a growing economy, payments may arrive more quickly.
Why Monitoring DSO Matters
Monitoring DSO enables firms to make more informed decisions about their credit rules and client relationships. High DSO suggests problems in the collection process or that the business is selling to clients that have low creditworthiness. This might result in problems related to efficient cash flow, making harder to pay suppliers, staff, or invest for expansion. A low DSO, on the other hand, may suggest effective credit management and a stable cash flow position.
Businesses that track DSO can discover trends and take appropriate action. For example, if DSO is increasing, businesses may need to review their collection practices or tighten credit criteria to avoid future cash flow issues.
Conclusion
Days Sales Outstanding (DSO) is an important indicator that determines how effectively a company manages its receivables and cash flow. A low DSO means a healthy business with effective credit and collection activities, though a high DSO suggests issues that needs to be addressed quickly. Businesses may keep control over their financial health by regularly monitoring DSO, ensuring they have enough cash flow to support operations and drive growth.
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