Days Sales Outstanding or DSO is a measure of accounts receivable. DSO is also known as average collection period, or receivable days. It’s a measure of the average time it takes to collect the cash from sales—in other words, how fast customers pay their bills.
DSO is impacted by both contractual terms (when can the invoice be issued?) and by the promptness of customer payment (did they pay the invoice on time?). The longer the number of days that accounts receivable is unpaid, the more expensive it is, because we don’t have the cash, even though we’ve provided the service, and we may have to borrow to pay our own bills. The shorter our DSO days, the better we are managing our cash, and the more flexibility we have to invest in our own business.
The formula for Days Sales Outstanding is:
The numerator of this ratio is ending accounts receivable, taken from the balance sheet at the end of the period you’re looking at. For our example, let’s assume it’s $1,000.
The denominator is revenue per day, take the annual sales figure divided by the number of days in a year, or 360 to use round numbers. For example, if our company’s revenues were $7,200, we would divide that number by 360 to determine our company generated $20 in revenue per day.
Using the DSO formula, our sample calculation looks like this:
DSO = $1,000 / $7,200/360
= $1,000 / 20
In other words, it takes this company’s customers an average of about 50 days to pay their bills.
(Excerpts from Financial Intelligence, Chapter 24 – Efficiency Ratios)
[Shortening DSO] is an avenue for rapid improvement in a company’s cash position. Why is it taking so long? Are customers unhappy because of product defects or poor service? Are salespeople too lax in negotiating terms? Are the receivables clerks demoralized or inefficient? Is everybody laboring with outdated financial management software? DSO does tend to vary a good deal by industry, region, economy, and seasonality, but still…[DSO] is a prime example of a significant phenomenon, namely that careful management can improve a business’s financial picture even with no change in its revenue or costs.
DSO is also a key ratio for the folks who are doing due diligence on a potential acquisition. A high DSO may be a red flag, in that it suggests that customers aren’t paying their bills in a timely fashion. Maybe the customers themselves are in financial trouble. Maybe the target company’s operations and financial management are poor. Maybe…there is some fast-and-loose financial artistry going on.
…It is by definition a weighted average. So it’s important that the due diligence folks look at the aging of receivables—that is, how old specific invoices are and how many there are. It may be that a couple of unusually large, unusually late invoices are skewing the DSO number.