Understanding Days Sales Outstanding (DSO): Key Calculation and Applications

What Is Days Sales Outstanding (DSO)?

Days sales outstanding (DSO) measures how quickly a company collects payment following a credit sale—a crucial factor in cash flow management. Calculated by dividing the accounts receivable by total credit sales and multiplying by the number of days in the period, a company’s DSO reveals its efficiency in managing receivables. This metric, part of the cash conversion cycle, is essential for assessing a company’s liquidity and financial health, and can significantly impact its operations. Understanding DSO can help businesses identify trends in their cash collection processes and make informed decisions regarding operational improvements.

Why Days Sales Outstanding (DSO) Matters for Your Business

Given the vital importance of cash flow in running a business, it is in a company’s best interest to collect its outstanding accounts receivables as quickly as possible. Companies can expect, with relative certainty, that they will be paid their outstanding receivables. But because of the time value of money principle, time spent waiting to be paid is money lost.

That said, the definition of “quickly” depends on the business. In the financial industry, relatively long payment terms are common. In the agriculture and fuel industries, fast payment can be crucial. In general, small businesses rely more heavily on steady cash flow than large, diversified companies.

$\begin{aligned}&\text{DSO} = \frac {\text{Accounts Receivable} }{ \text{Total Credit Sales} } \times \text{Number of Days}\\\end{aligned}$​DSO=Total Credit SalesAccounts Receivable​×Number of Days​

Interpreting DSO Numbers for Financial Health

A high DSO indicates that a company sells on credit and takes a long time to collect payments.

This can lead to cash flow problems. A low DSO value means that it takes a company fewer days to collect its accounts receivable. That company is promptly getting the money it needs to create new business.

Knowing how long it takes to collect receivables can reveal much about a company’s cash flow.

Remember, DSO calculations only include credit sales. While cash sales may be considered to have a DSO of 0, they are not factored into DSO calculations. If they were factored into the calculation, they would decrease the DSO, and companies with a high proportion of cash sales would have lower DSOs than those with a high proportion of credit sales.

Practical Uses of Days Sales Outstanding in Business Analysis

There are many ways to analyze days sales outstanding. It suggests how efficient the company’s collections department is, and the degree to which the company is maintaining customer satisfaction. It also helps identify customers who are not creditworthy.

Analyzing a company’s DSO for a single period can quickly assess its cash flow. However, trends in DSO over time are much more useful. They can act as an early warning sign of trouble.

Evaluating DSO Values: What’s Considered Optimal?

An increasing DSO is a warning sign of potential problems. Customer satisfaction might be declining, or the salespeople may be offering longer terms of payment to drive increased sales. Perhaps the company may be allowing customers with poor credit to make purchases on credit.

A sharp increase in DSO can cause a company serious cash flow problems. If a company’s ability to make its own payments in a timely fashion is disrupted, it may be forced to make drastic changes.

Generally, when looking at a given company’s cash flow, it is helpful to track that company’s DSO over time to determine if its DSO is trending up or down or if there are patterns in the company’s cash flow history.

DSO may vary consistently on a monthly basis, particularly if the company’s product is seasonal. If a company has a volatile DSO, this may be cause for concern, but if its DSO regularly dips during a particular season each year, it could be no reason to worry.

Recognizing the Limitations of DSO as a Financial Metric

As a metric attempting to gauge the efficiency of a business, days sales outstanding comes with a limitation that is important for any investor to consider.

When using DSO to compare the cash flows of a number of companies, you should compare companies within the same industry, with similar business models and revenue numbers. If you try to compare companies in different industries and of different sizes, the results you’ll get will be misleading because they often have very different DSO benchmarks and targets.

When DSO Is Not As Relevant

DSO is not particularly useful in comparing companies with significant differences in the proportion of sales that are made on credit. The DSO of a company with a low proportion of credit sales does not indicate much about that company’s cash flow. Comparisons to companies with high credit sales don’t reveal much either.

In addition, DSO is not a perfect indicator of a company’s accounts receivable efficiency. Changes in sales volumes can affect DSO; higher sales often lower the DSO.

Delinquent Days Sales Outstanding (DDSO) is a good alternative for credit collection assessment or for use alongside DSO. Like any metric measuring a company’s performance, DSO should not be considered alone, but rather should be used with other metrics.

The Bottom Line

In many businesses, the days sales outstanding number can be a valuable indicator of the efficiency of the business and the quality of its cash flow. If the number gets too high, it could even disrupt the normal operations of the business, causing its own outstanding payments to be delayed. In any case, cash delayed is cash lost to your business.