Everything You Need To Know About DSO: Definition, Calculation, And Optimization

Let’s face it — businesses globally are facing drastic demand fluctuations, supplier shortages, liquidity pinches, and continually soaring operation costs. Therefore, more than ever, it’s crucial today for finance leaders to ensure their organizations achieve the lowest DSO possible.

Read on to learn about DSO calculation and optimization.

What is DSO?

Day Sales Outstanding, DSO, is a measure of the number of days it takes a business to collect payments from its account receivables (AR). A higher DSO means a company takes longer to convert its AR into cash, while a lower DSO means customers settle their debts on time. Most organizations calculate their DSOs monthly, quarterly, or annually.

Why is DSO Important?

A company’s DSO is a crucial metric for measuring its financial health. A low DSO means your clients respect your credit policy, which, in turn, enhances your firm’s liquidity. On the other hand, if it takes your business too long to collect cash from customers, you risk running into cash flow problems.

Analyzing your DSO can also help determine customer satisfaction. Usually, the assumption is the more valuable clients find your products, the higher the chances they’ll pay for them on time.

How to Calculate DSO

You can calculate your DSO using either of the following two formulas:

The Simple DSO Formula

DSO = (Account Receivables at the end of the period ÷ Gross revenue over the period) × Number of days in the period

Suppose your sales at the end of the year stand at $800,000, and your account receivables are $40,000.

DSO = (40,000 ÷ 800,000) × 365 = 18.25 days

This method may not always be accurate because it doesn’t account for your company’s seasonality. Instead, it uses the average days you took to convert your AR into cash.

The Countback DSO Calculation Method

This method is more accurate as it accounts for the receivable balance and gross sales per month across the period of interest. Identify these two variables from your balance sheet and compare them month by month:

If your monthly net sales exceed your AR, divide the gross sales by AR and multiply by the number of days in that month to derive the outstanding ratio.

If your monthly AR is higher than the net sales, add the number of days within that month to your DSO calculation (starting from zero). Subtract your net sales from the AR when moving back a month.

How to Optimize Your DSO

The ideal DSO varies from one industry to another. For example, according to a recent Inc. and SageWorks publication1, the Management consulting sector has the highest average DSO of 125.07 days, while Heavy and civil engineering construction businesses have the lowest average DSO of 66.51 days. However, regardless of your industry, a DSO above 3-4 months might be too high to maintain a healthy cash flow.

So, how do you optimize your DSO? Below is a step-by-step guide:

Collect Data on Your Current DSO Status

Create a benchmark analysis to compare your DSO with industry peers and competitors. Reviewing your DSO status can help identify why you’re not meeting your collection targets. And most importantly, it can help assess financial realities and determine sustainable and attainable DSO ratios.

Review Your Customers’ Credit Risks

One of the most crucial determinants of a company’s DSO lies in its customers’ ability to service debts on time. Define the credit approval process and prerequisites, such as upfront deposits. You may also apply these criteria to existing customers seeking additional or new credits. In this stage, you can define specific penalties and incentives to ensure salespeople and customers adhere to your credit policies.

Outline Clear Customer Payment Terms

Another DSO optimization tactic is defining clear payment terms and ensuring clients understand them. Sometimes, you might think clients deliberately defaulted on their payments, yet they genuinely didn’t know when these payments were due. You can avoid this by outlining clear payment terms in your invoices. It also helps to continually remind customers of upcoming payments and how to sort them.

Streamline Your Accounting Process

Sluggish or disorganized accounting processes can also increase the days your business takes to sort its AR. Consider optimizing your DSO by sending invoices on time and ensuring your accounts are as accurate as possible to minimize unnecessary back-and-forth. Ensure your invoices contain all the necessary information, including payment processes and account numbers.

Be Consistent

Lowering DSO doesn’t take a few days. Instead, it requires a consistent collective effort from all departments. Review your DSO status regularly and continually train your staff on streamlining your accounting processes, especially those in the sales and finance departments.

Reduce Your DSO and Increase Cashflow

Maintaining a low DSO enhances an organization’s liquidity, increasing its cash flow. When clients take long to settle their debts, you’re extending an interest-free loan to them. The longer they take, the less liquid cash you’ll have to finance your daily operations, exposing you to a cash crunch risk.

Fortunately, you can solve this by making simple but crucial adjustments to your accounts processes. Screen customers thoroughly before approving credit requests, send invoices on time, continually remind clients of upcoming payments – and repeat these steps over and over.