Complete Guide to Understanding DSO

Dimitri Raziev23 Dec 202212 mins
Complete Guide to Understanding DSO

Key Points

– Days sales outstanding (DSO) is defined as the mean number of days that a firm takes to receive payment for a previous sales transaction.

– A high DSO value indicates that the corporation has been facing delays in getting their clients’ payments, thereby suggesting the business may be facing a cash flow issue internally.

– Meanwhile, a low DSO number suggests that the company is receiving its payments relatively on time, in which the money can be reinvested into the business operations for good use.

– In general, having a DSO below 45 days is considered low and a good target for corporations to achieve.

In today’s business world, it is fairly common for companies to extend credit to their business-to-business (B2B) enterprise clients, permitting them to buy a product and/or service today whilst settling the payment for it in the future within a specified period. On that note, the amount of money the client owes the business would be recorded as an account receivable in the company’s books. Meanwhile, the time taken for the client to settle their debt is classified as the days sales outstanding (DSO). Therefore, if the company manages to convert its sales transactions into cash quickly, it would stand a greater chance of being able to reinvest the money earned back into the business. As a result, DSO serves as a critical operational metric that firms ought to track consistently.

Having said that, one of the best tools in which companies should consider adopting would be Kolleno, a smart credit control software designed to help businesses elevate their levels of productivity by eliminating as many manual accounting tasks as possible. Thus, companies would be able to track their DSO performances while minimising risks associated with human error.

On that note, Kolleno offers a smart credit control platform with the right tools to help businesses achieve their target DSO ratio. More specifically, the accounts receivable software by Kolleno can automatically deliver payment reminders to customers upon the nearing of their invoice due dates. Plus, the ability of the software solution to digitalise the manual accounts receivable processes allows companies to greatly minimise any problems associated with human errors.

Defining the Days Sales Outstanding Ratio

The days sales outstanding (DSO) ratio is a metric gauging the average number of days a firm usually takes to collect cash after it has closed a sale transaction; whereby its formula is illustrated below:

Simply put, DSO is a key performance indicator (KPI) used to study the company’s accounts receivables. It is often evaluated on a month-on-month or quarter-on-quarter basis. In essence, tracking the DSO would be extremely advantageous to the business once they have comprehended the procedure behind its calculation.

Understanding the Days Sales Outstanding Ratio

Due to the importance of having a healthy operational cash flow when running a company, it would be in the firm’s best interest to ensure that it collects all outstanding accounts receivables as soon as possible.

Technically speaking, firms could expect with some degree of confidence that they would be paid for their outstanding accounts receivables. However, due to the time value of money concept, any time spent waiting for the debt to be settled would be equal to money lost.

Having mentioned that, different businesses may have varying definitions of what “quickly” would mean. For instance, having an extended credit period is considered to be fairly common in the world of finance. However, secured debt settlements are critical for the energy and agriculture sectors. Other than that, smaller firms are typically more dependent on having a stable and positive cash flow compared to large multinational corporations, which may have a diverse range of revenue streams.

Interpreting the Days Sales Outstanding Value and its Implication for Businesses

All in all, measuring the mean time taken for a corporation’s outstanding accounts receivables to be settled may present important information regarding the health and nature of its operating cash flow. Meanwhile, it is also crucial to take note that the DSO ratio formula only takes credit sales into account whilst excluding cash sales. This is because including cash sales in the calculation will lower the DSO, thereby distorting the accuracy.

In essence, companies with a high DSO ratio imply that they are spending a lot of time waiting for the customers on credit to repay their debts. Therefore, this may mean that such firms could be taking on clients with poor credit ratings, offering longer credit terms to boost their sales performance, facing a declining customer satisfaction rate, and/or experiencing severe cash flow issues. On the other hand, businesses reporting a low DSO ratio suggest that they are taking a shorter period to settle their accounts receivables, so they are promptly receiving the cash required to grow their businesses.

Generally speaking, it is useful to monitor a firm’s DSO ratio over a period to evaluate if its DSO is trending upwards or downwards, as well as determine if there may be meaningful patterns in the business’ historical cash flow performance. This is because a company’s DSO value could change regularly on a month-to-month basis, especially if its products and/or services are of a seasonal nature. Should a business present a volatile DSO performance, this would be a cause for concern. However, if its DSO declines during a specific season every year, it may simply be a natural phenomenon that the management need not worry about.

Other than that, the implications of having a high or low DSO ratio are also based on the size of the company, so there is no cookie-cutter assumption that one could make based on the raw DSO value itself. For instance, while reporting a DSO ratio of 45 days is considered good, this may still be a worrying case for small-scale businesses with an extremely tight cash runway. Hence, it is necessary to view the DSO value based on the case-specific context.

The Benefits of Tracking Days Sales Outstanding Regularly and Its Applications

The DSO ratio is a helpful metric for analysts to assess a business for various important aspects, such as how fast its clients are at settling their debts, the company’s liquidity, and the number of successful sales the company has made over a specific timeframe, the level of client satisfaction, the efficacy of the firm’s sales and customer services teams, as well as the client retention rates.

With that, by periodically monitoring a company’s DSO ratio performance, the management can then make the necessary adjustments to the firm’s business model and practices. Essentially, most companies measure their DSO regularly as opposed to making their improvements based on individual DSO outcomes. Simply put, some of the key actionable steps that companies can take based on their evaluation of the DSO performances include:

– Devising better strategies motivating the payment collections department to maintain a strong proactiveness in keeping outstanding accounts receivables at a minimum.

– Providing an improved in-house training programme for the customer service department to ensure that the clients are satisfied with the company’s product and/or service offerings.

– Establishing a stricter policy for the sales department regarding the payment terms the firm is comfortable with extending and/or the specific types of clients that the business is open to working with based on their credit histories.

– Identifying clients who have repeatedly been making late payments so that the company can make the necessary amendments for their future payment terms.

– Developing more comprehensive credit check policies for future clients before proposing the appropriate credit terms or exclusive payment plans for customers who have been prompt with their previous debt settlements.

What are the Limitations of the Days Sales Outstanding’s Relevance?

Although the DSO ratio has its practical applications in helping analysts determine a company’s efficiency at managing their credit sales conversion to cash, there are some limitations associated with the DSO value that all professionals must understand.

To begin with, analysts ought to only compare the DSO ratios between companies operating within the same industry vertical coupled with a similar revenue performance and business model. The reason for this is that the outcomes of contrasting businesses of different sizes and sectors would lead to misleading results. Plus, different firms would typically have varying benchmarks and targets for their DSO values due to the nature of their business operations.

Moving forward, the DSO is not very applicable if one were to compare firms that have substantial differences in terms of the proportion of sales completed via credit terms. This is due to companies with a low number of credit sales usually lacking meaningful data points regarding their DSO values and, thereby, operational cash flow performance. Thus, contrasting businesses with those that predominantly run on credit sales would bring limited actionable insights. Besides that, the DSO ratio is not the perfect metric to assess the accounts receivable efficiency of a corporation as fluctuating sales performances may impact its value, whilst any increments in sales volume can drastically lower it.

Alternatively, analysts may want to consider other metrics, such as the delinquent days sales outstanding (DDSO) together with the DSO ratio, as part of investigating a company’s credit collection capabilities and efficiency. In other words, the DSO value should not be the sole factor to be considered but rather a complementing element to be viewed alongside other working capital metrics.

How Could Companies Lower Their Days Sales Outstanding Figures?

In short, there are a wide variety of strategies that all companies could employ to lower their respective DSO values. Such tactics, for example, would include:

Providing Incentives for Clients Who Are Punctual or Early with Their Payments

In general, offering rewards for early-paying clients has been a well-known tactic that companies adopt to accelerate their payment procedures because early-bird discounts and perks have always attracted customers. On the contrary, the firm could also consider setting hefty penalties for clients who have been constantly late with settling their outstanding debts. Therefore, it is vital for businesses to make sure that their invoices contain explicit terms and conditions regarding the consequences of any late payments.

Extending The Range of Payment Options for The Clients

Increasing the types of acceptable payment options, such as bank transfers or credit card transactions, may help the firm settle its outstanding accounts receivables sooner. This is because the clients would now have an increased level of convenience to make their payments according to their preferences. Not to mention, offering the option for clients to complete their payments online would usually enable businesses to be paid faster in comparison to the offline methods of payment.

Maintaining Records of the Clients’ Payment Details

If the company happens to be running a business with a subscription-based revenue model, auto-charging its clients might be the optimal approach to managing its DSO ratio. On that note, the firm ought to consider keeping records of its client’s credit card details so that they can be automatically charged on a set date each month. In addition, all the company needs to do is to ensure that the customers are well-informed about this policy upon the establishment of such payment systems. Besides that, the company will also need to have its clients notified every time a payment has been drawn from their bank accounts.

Eliminating Business Ties with Bad Clients

Although maintaining strong customer retention is crucial, should a client consistently make late payments despite multiple penalties and gentle reminders, the company should contemplate ending its business relationship with them.

Another way for businesses to make a decision on this matter would be to determine the likely cost and reward for maintaining a particular client. If the benefits fail to outweigh the expenses associated with retaining them, continuing business ties with them may not be worthwhile in the long term.

Adopting Online Invoicing Software

Given its sheer importance, the company’s payment collection procedure should be a highly systematic and organised process. Hence, investing some capital in an online invoicing software solution would empower businesses to eliminate time-consuming and manual accounting tasks whilst promptly invoicing their clients as soon as a sale has been closed. Meanwhile, using automated invoicing software may enable firms to monitor a client’s payment status, establish automated payment reminders to be delivered at a specific interval, and create customised invoices based on the individual clients. 

With that, Kolleno is a smart credit control platform that may be the perfect solution for all businesses out there. In particular, the accounts receivable software by Kolleno is excellent at automating manual accounts receivable procedures, thereby aiding businesses in lowering their DSO values. Not to mention, the software can also provide and deliver well-crafted invoices to clients promptly, set the appropriate credit terms, and handle payment collections methodically. Consequently, all of these robust features provided by Kolleno can help firms elevate their liquidity as well as shorten their credit-to-cash cycle to capture new business development opportunities in the long run.

Concluding Thoughts

In a nutshell, the days sales outstanding (DSO) ratio is an essential metric that B2B-centric companies need to track in order to assess the financial health of their businesses consistently. The lower the DSO value, this implies that the firm takes a shorter duration to convert their credit sales into capital, thereby suggesting a healthier cash flow. Conversely, the larger the DSO ratio, the greater the period taken by the client to settle its outstanding accounts receivables, thus shedding light on a possibly tighter operational cash flow for the company. As a result, the firm would be able to devise the relevant strategies to lower the DSO value.

To assist companies with achieving such goals, finance professionals ought to consider using a smart credit control platform called Kolleno. Simply put, Kolleno possesses an industry-leading all-in-one accounts receivable software platform. Its credit control solution, in combination with the company’s premium-quality customer success department, offers customised services to enable firms to manage their DSO ratios in a much more effective manner.

Frequently Asked Questions (FAQs)

What are Days Sales Outstanding (DSO)?

Days sales outstanding (DSO) can be defined as the mean number of days a company takes to have its clients repay their debts for a previous sales transaction. In other words, DSO represents how long a firm takes to collect its outstanding accounts receivables.

How is the Days Sales Outstanding Value Calculated?

The DSO ratio can be calculated by dividing the total amount of accounts receivable a company has within a specific period of time by the total dollar value of its credit sales during the same timeframe. Following that, this figure should be multiplied by the number of days in the measured duration.

What Would Be Considered a Good Days Sales Outstanding Ratio?

A healthy or concerning DSO ratio would largely depend on the nature of the business and the industry verticals in which the firm is operating. Having mentioned that, maintaining a DSO below 45 days would often be considered the best practice for the majority of companies, as it indicates that the company has a reasonably healthy operational cash flow and thereby has enough money which it can readily reinvest into its business.