Days Sales Outstanding (DSO) is an accounting metric that refers to the average number of days it takes a business to collect payment for products and services provided. DSO is generally taken as a measure of the business’s efficiency and its effectiveness at converting sales to actual revenue or cash.
The lower the DSO, the more efficiently the business is operating. It is especially applicable to the accounts receivable (AR) process, which is responsible for collecting payments owed to the business.
DSO is part of a larger collection of metrics that reflects on the business’s overall effectiveness at converting cash to even more cash. Collectively, this is referred to as the cash conversion cycle (CCC). The CCC calculates the net aggregate time along three stages.
The first measure, Days Inventory Outstanding (DIO), quantifies how long it takes for a business to convert inventory that it has purchased into sales
The second metric is the DSO
Finally, the Days Payables Outstanding (DPO) measures how long it takes for the business to pay off its own purchases
A lower CCC number indicates that the business is efficiently converting initial cash into more cash. In other words, it is effectively converting its initial investment into revenue.
By itself, the DSO is an important metric because all businesses need cash to function. A business must meet its payroll obligations; pay utilities, rent, and overhead; purchase additional supplies and inventory; and pay down loans and other debt. Without cash, the business cannot meet these obligations and will have trouble functioning. Converting sales to cash supports ongoing business operations.
It reflects effective management, and in particular, a functioning accounts receivable department.
Examined more closely, DSO reflects not just on the way a business collects its accounts receivable. It also reflects on how the business manages the credit that it extends to customers. All businesses have a choice to makes sales for cash or credit. Ideally, all sales will be made in cash, and the business will have a steady infusion of cash to support its ongoing payment obligations.
In the real world, many customers want and need to make purchases on credit, and it is a good practice for the business to extend credit. This builds trust and good will with customers, and it helps generate more business. However, poorly managed credit can lead to a higher DSO.
If it takes too long for the business to convert sales to cash, this may be an indication that the business is being too lenient with the extension of credit and its cash conversion its suffering. Ideally, the business will want to extend credit while still maintaining a low DSO.
The DSO is calculated simply as the value of the accounts receivable divided by the total number of sales on credit, then multiplied by the number of days. The equation is represented mathematically as:
(Accounts Receivable ÷ Credit Sales) X Number of Days = DSO
In this manner, the DSO is essentially a representation of the total amount of payments to be collected as a proportion of the total amount of credit that has been extended over time.
The product represents an average for the time it takes during the accounting period for accounts receivable, or credit sales, to be collected.
In this equation, the number of days represents the number of days in the accounting period. The figure for accounts receivable can be either the total ending value for the accounting period or an average for the period.
In the case of an average, the accounts receivable would be calculated as the beginning balance plus the ending balance, then divided by two:
(Beginning Accounts Receivable + Ending Accounts Receivable) ÷ 2
DSO is an important metric of the efficiency of a business. It reflects on the performance of management and accounting staff. A business that is effectively converting sales to cash is generally considered a well-run business.
DSO is an important metric for management as well as investors. A business that effectively converts sales to cash will more likely be able to meet its payment obligations and continue to grow. A low DSO is an indicator to management that things are running smoothly.
Investors and lenders may also consider the DSO, along with many other metrics, to determine if the business is viable as an investment or for a loan. A business with a low DSO has the potential for a good return on investment. Likewise, a business with a low DSO will have sufficient cash to repay a loan.
If a company made $100,000 in credit sales for the month, and $50,000 of those sales were in accounts receivable because they had not yet been paid, the DSO would be calculated as follows:
Step 1: $75,000 ÷ $100,000 = .75
Step 2: .75 X 30 (days in the month) = 22.5
The DSO in this example is 22.5, which means that it takes an average of 22.5 days for accounts receivable to be collected.
There is no universal standard for a “good” DSO. What is accepted as a good DSO varies from one type of business to another. The nature of the business and the industry it operates in reflects how quickly a business can be reasonably expected to convert sales to cash.
For example, businesses in the food and retail industries are less likely to extend credit to customers. They would be expected to have a low DSO, perhaps in the range of 20.
Other industries, such as construction and development, which are highly leveraged on financing, can be expected to have a much higher DSO, up to and exceeding 80.
Differences in industries notwithstanding, as a general rule, a good DSO is considered to be anything below 45.
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