What is Days Sales Outstanding (DSO)? | Definition, Formula and Benefits

What is Days Sales Outstanding (DSO)?

Days Sales Outstanding is an important metric used in Accounts Receivable Management that indicates the average period of time a company takes to collect the amount it owes from the credit sales in order to make strategic decisions for improving the company’s liquidity, improving sales efficiency, and mitigating the risk of bad debts.

DSO calculation provides a glimpse of the company’s collection efforts and overall credit policy effectiveness. DSO ratio varies from industry to industry and company size. It is typically tracked on a trend line on a month-wise basis. In the case of seasonal fluctuations, they are compared with the seasonal fluctuations in the preceding year in the same duration. When a large corporation plans the acquisition of a small company, it uses the Days Sales Outstanding formula before pumping in more working capital to reduce the acquisition cost.

Days Sales Outstanding Formula for DSO Calculation

Now that we’ve already discussed what is DSO, let us discuss the formula for DSO calculation.

Akash, a small computer seller sells computers and laptops to his customers on the condition that they should make the full payment within 30 days. While a majority of his customers make timely payments, some sections of the customers delay it. Now, Akash wants to perform DSO calculation using the DSO formula to find out the efficiency of his Accounts Receivable process.

Here’s the Days Sales Outstanding formula:

Days Sales Outstanding = (Accounts Receivable / Net Credit Sales) x Period (Number of Days)

Our Days Sales Outstanding formula requires entering the following figures:

• Accounts Receivable: This is the amount that the business is yet to receive for the goods & services sold to its customers
• Net Credit Sales: This amount indicates the total amount of sales the company has made on credit, minus sales returned and allowances
• Period (Number of Days): Describes the period of net credit sales (indicated in the number of days).

Days Sales Outstanding (DSO) = (60,000 / 360,000) x 365 = 60 Days

This indicates that Akash’s Accounts Receivable process is inefficient. Even though the targeted credit period is only 30 days, the actual Days Sales Outstanding (DSO) is as high as 60 days. Akash must implement a rigid credit policy, encourage customers to pay on time with discounts & incentives and penalize late-paying customers.

High DSO vs Low DSO

A company may have either a higher or lower DSO. An average Days Sales Outstanding (DSO) of 45 days can be considered satisfactory for most large companies whereas it may be problematic for small companies that often face cash flow issues.

What are the Signs of a High DSO?

How do you know if you have a high Days Sales Outstanding (DSO)? Here are the most common signs:

• You’ve got a significant number of customers with negative credit standing
• You’re making new credit sales but you not getting their timely payments
• You’re frequently facing liquidity crunch and operational disruptions
• You’re over-depending on credit sales to boost your sales
• Your debt collection process is very slow

What are the Benefits of Reducing DSO?

If your business has a relatively higher DSO, it’s a good idea to reduce it. Here are the major benefits of reducing your DSO:

1. Increase Influx of Cash

One of the major benefits of reducing your Days Sales Outstanding (DSO) is that it improves the company’s cash flow statement and frees up capital to invest in different projects & investments. For example, a company operating in the auto ancillary industry can divert money obtained from reduced DSO on research & development, and manufacturing of new car models.

2. Reduced Bad Debts

Bad debts are the amounts that customers are unable to pay for the company’s goods or services. A company must control bad debts by implementing strict policy measures such as setting reasonable credit limits and maintaining regular communications with customers. Too much bad debt can hamper a company’s ability to perform its day-to-day operations and negatively affect the financial statements. The management may use the DSO formula and the Receivables Turnover Ratio together to measure the effectiveness of the company’s ability to extend credits and collect debts.

3. Financial Stability

A lower Days Sales Outstanding (DSO) improves financial stability, simplifies cash flow projection, and ensures employees are more focused, productive, and committed to the business. It contributes to less stress and anxiety. Moreover, sound financial statements indicate efficient risk management and credit policies. It helps improve the trust of individual and institutional investors.

4. Better Financing Options

A company with inadequate financial liquidity may disparately need to obtain loans and credit lines to fund its day-to-day operations. As a result, it may find it difficult to obtain loans at competitive prices. In contrast, a company with lower Days Sales Outstanding (DSO) and better financial stability will find it easier to negotiate with lenders and get loans at lower interest rates.

5. Process Standardization

Companies implement automated billing and collection mechanisms found in the best ERP software in India to reduce DSO. It promotes standardization, transparency, and accuracy in various business processes from sales management, and invoice generation, to billing. As a result, it becomes easier to track customer payments and take appropriate measures to reduce bad debts.

Effective Strategies to Reduce Your DSO

As we’ve already discussed what is the full form of DSO, and what are its benefits and limitations, now let us move to the most effective strategies your organization can employ to reduce the DSO.

1. Incentivize Early Payments

You can motivate your customers to make early payments before the agreed date by providing discounts and coupons. If none of your competitors are providing early payment incentives, you can gain an edge over them. Increased inflow of cash will reduce your company’s dependence on debt financing.

2. Send Automated Payment Reminders

A carefully drafted email copy can serve as an important reminder for your customers to pay their dues and avoid late charges. Nowadays, businesses automate debt collection through a comprehensive accounts receivable automation tool. Automated payment reminders reduce manual efforts and allow your employees to focus on more productive tasks.

3. Offer Diverse Payment Options

Some customers may delay their payments due to a lack of convenient payment modes. Instead of penalizing such customers, your best bet is to offer diverse payment options so that they can use their convenient mode of payment for making regular payments. If you’re targeting buyers in different countries across the world, provide regional payment options.

4. Provide Partial Payment Option

One of the most effective strategies to improve your DSO is to provide a partial payment option to your customers. For example, you can work with banks and credit card providers to facilitate EMI or No-cost EMI options. Such flexibility in the payment options enhances the customer’s buying experience, improves customer relations, settles debts voluntarily, and improves your conversion rate.

5. Penalize Late Payments

Late payments are extra charges levied on customers for making payments after the end of the billing cycle. Much like it’s important to incentivize early payments, penalizing late payments can help maintain a healthy cash flow and encourage customers to make regular payments.

What are the Limitations of DSO Calculation?

While Days Sales Outstanding (DSO) is an important measure to identify the efficiency of Accounts Receivable, it has its limitations:

1. Festival Sales

One of the limitations of DSO calculation is that it doesn’t take the fluctuations caused during festival sales into consideration. During major festivals such as Diwali and Ganapati, many businesses across India run promotional offers and discounts to boost their sales and attract new consumers. During such festivals, businesses may experience a lower DSO. In contrast, during the off-peak months, they may experience a higher DSO. Such changes in the DSO can lead to incorrect conclusions if decision-makers consider only one factor: the DSO formula.

2. Invoicing Errors

Businesses that manually generate invoices are prone to human errors. Sometimes, employees may forget to issue an invoice. Or, there may be errors in the invoice date, invoice number, due amount, or name of the company to whom it was issued. Such manual errors in the invoicing process can lead to incorrect DSO calculation. As a result, decision-makers may not get a realistic idea of the efficiency of the company’s Accounts Receivable. Companies can prevent that by implementing a robust invoice management system.

3. Changes in Credit Policy

It’s a common practice among companies to change their credit policy from time to time. A sudden change in the company’s credit policy can affect DSO calculation. For example, a company may initially have a credit policy of 30 days period. After a few months, the company suddenly extends the credit period to 90 days due to recession or other economic reasons. This can impact the DSO calculation. A sudden increase in the credit period can create a false impression of inefficient Accounts Receivable Management.

4. Bulk Orders

Companies often receive bulk orders for their products. During a bulk order, both buyer and seller negotiate about the order quantity and credit period. If a bulk order has an unusually higher credit period such as 90-180 days, a single such order can create a disproportional effect on the existing DSO calculation. Relying on such data can lead to inaccurate results and poor decision-making.

5. Disproportional Sales

A company may not receive an equal amount of sales all the time. It may receive several smaller orders that remain unpaid over a longer period, and a few large orders that are paid in a short span of time. Such disproportional sales could lead to an inaccurate picture of the company’s overall receivables. If the decision-makers rely on such data, it can lead to inaccurate outcomes and problems in strategic decision-making.

Wrapping Up

Days Sales Outstanding is an important measure to identify how long your customers take to pay for credit sales. ERP software can help you lower the DSO to maintain an optimum liquidity level and ensure efficiency in sales operations.

Sage X3 is a top-notch solution that streamlines DSO calculation, invoice & billing operations, automated payment reminders, payment tracking, and credit limit monitoring. By deploying it in your company, you can reduce manual work, improve DSO, and bring down your dependence on debt financing.

FAQs

1. What is the Definition of Days Sales Outstanding?

DSO meaning is that it is the average number of days a company takes to convert credit sales into cash, or the number of days a company takes to collect the funds customers owe it. It is an important measure that helps companies identify the efficiency of the sales department, avoid high-risk customers, reduce financial risks, and lower administrative burdens.

2. What is the DSO Full Form?

The DSO full form is Days Sales Outstanding, which is measured in the number of days required to collect the amount of the credit sales. An organization may calculate the DSO Ratio monthly, quarterly, or annually depending on the volume of sales and its Accounts Receivable policy. The lower the DSO, the better for the organization. An organization with high DSO should take appropriate measures and policy decisions to reduce it.

3. What is the Average Industry-wise DSO?

The average DSO differs from industry to industry. Here are the industry averages for Indian industries:

• Manufacturing Industry: 45-55 Days
• Automotive Industry: 40-60 Days
• Pharmaceutical Industry: 45-55 Days
• Retail Industry: 30 Days
• Information Technology (IT) Industry: 25-55 Days
• Telecommunications Industry: 45-70 Days
• Consumer Goods Industry: 30-50 Days
• Textile Industry: 60-90 Days

4. What is the Difference Between DSO & DPO?

DSO stands for Days Sales Outstanding, which indicates the amount of time your customers take to make payments for the goods or services they have already received. In contrast, Days Payable Outstanding (DPO) is the amount of time your organization takes to make payments to vendors for the goods or services received. Both are interlinked concepts. Your business can use accounts payable software to streamline the bills payable to your vendors and creditors.

5. How to Calculate DSO in Excel?

There are many third-party Macro-enabled Excel templates available that simplify the Days Sales Outstanding (DSO) calculation. You need to fill up the required data into the designated cells such as Total Credit Sales Data and Accounts Receivable. You will also need to select a duration (for example, Monthly or Annual). However, the better way is to use an ERP application that consolidates data from different departments across your organization and streamlines the entire process. It provides real-time charts, graphs, and visual representation to help decision-makers make informed decisions.