CFO, CEO, why you should track your DSO, and how to measure it
Aug 19, 2022
We often hear that the top-performing companies manage their working capital efficiently, and have strong control over their cash flows. But what does this actually mean?
From a financial perspective, simply put, businesses have both cash inflows and cash outflows. At an operational level, your business needs to ensure that you’re keeping your company's accounts above the floating line, i.e. cash collection for customers covers your cash outflow to suppliers.
Ideally, you not only stay above the floating line but optimize these cash flows, and collect cash faster than spending it!
Today, we'll focus on a key item of cash inflows: measuring how your business gets paid by customers.
Read on to learn more about ;
1/ what is DSO
2/ why it's important for your business and
3/ how to measure your DSO.
Check out our free spreadsheet to calculate, interpret and improve your DSO!
What is DSO?
DSO stands for "Days Sales Outstanding". Alongside Days Payable Outstanding and Days Inventory Outstanding, DSO is a key metric in the Cash Conversion Cycle. In simple words, it’s the time it takes your business to get paid for credit sales by your customers. It’s usually measured in a number of days.
DSO is the average number of days between 1/ invoice issuance, and 2/ payment received. For online businesses and companies with high levels of cash sales, that’s usually 0 days, as you’re invoiced immediately when you pay. Easy. For B2B businesses issuing invoices "net 30" to Customers, in an ideal world, this number should be 30 days. Simple right?
Well… that's the theory. The reality is that a lot of businesses still struggle to get paid on time by Customers and their DSO is way higher than their payment terms. According to Atradius, nearly 50% of B2B invoices in the US are paid late, creating significant cash flow problems for suppliers.
What does your DSO number mean and why is it important?
Your DSO is an indication of how long it takes your company to get paid. You should think of your DSO in relation to your average payment terms:
High DSO: To ensure your business is running efficiently it's important to collect outstanding account receivables as quickly as possible. If your DSO is too high, it means that your business takes too much time to collect cash from your Customers. You are basically offering a loan to them on money that should be in your bank account! In the meantime, you may need to pay your suppliers and use your own treasury to cover the finance gaps, in particular, if you’re growing. On top of financing them, you also bear the risk of payment failures, as overdue invoices are much more likely to never get paid…. Don’t get there. Take action to lower DSO as soon as possible.
Low DSO: If your DSO is approximately equal to that contained in your payment terms, it means your business is collecting cash efficiently from your customers. Customers pay on time when they’re happy about the service you deliver. Businesses with a low DSO often have a strict credit policy and reward customers for upfront or early payment. Having a low DSO will also please investors as it’s a fundamental indicator of liquidity. You’re in a position to pay your suppliers on time and grow your business in a healthy way. That’s great, keep it this way!
DSO is a key performance indicator for your finance team as it will give you a good sense of how efficient your business is at collecting cash over a certain period of time. This is usually a good proxy for the quality of your relationship with your Customers. It will also help you with your financial planning, as it will give you a more realistic estimate of your future cash collection. Decreasing DSO can help to boost profitability.
Reasons why businesses don't get paid on time
Business owners often complain about late-paying customers. But why does that happen?
There are many reasons. Remember that when your Customer receives your invoice, it's not a guarantee that you will get paid.
Here are a few reasons for late payments:
Customers may need to go through complex approval workflows before processing a payment;
Customers may just simply forget about their supplier invoices when it's lost between 100 other emails. More generally, companies usually don't have the right tools to manage their outstanding invoices and receivable process ;
The invoice might be sent to the wrong person or lacks some data required to proceed to payment (such as a PO number);
Customers may dispute the invoice based on goods or services not being delivered as they were expecting and requiring a credit note or a rebate;
Inefficient payment processing tools and outdated payment methods may create additional complexities or delays. Wire transfers may take a few days to appear on your bank account, and checks can be lost in the mail.
And the problem is, quite often, that Customers do not proactively reach out to their suppliers when such a problem occurs. That's why B2B merchants need to be proactive about tracking unpaid invoices if they don't want to end up with late payments, and cash flow issues. In that respect, DSO is the most synthetic indicator of the efficiency of a company's cash collection process.
But before trying to improve it, the first basic step is to measure your DSO. Here is how.
How to calculate your DSO?
As a CFO or CEO in charge of your business finances, tracking your DSO should be a top priority. Again, that’s on average the number of days between invoice issuance and payment.
To calculate the DSO you'll probably need to gather information from an aged accounts receivable report or your balance sheet.
But it can get tricky:
It should be weighed against the value of the invoices (you probably wouldn’t care as much as about a small invoice being paid late as a really large one)
If you have a seasonal business with peaks of invoicing, you should account for the fact that you’re likely to have more temporarily unpaid invoices.
At any given time, you should allow for “opened” invoices, which are invoices you’ve issued but not yet collected. It may seem obvious but if invoices are already overdue, they will be paid late or possibly even never get paid, so you should definitely account for them when reporting your DSO. Let’s examine two methods of calculating your DSO.
1/ A simple method for calculating DSO
Here’s a back of the envelope method for calculating your DSO. Very simple!
Let’s say your business is making $1,200,00 net annual turnover. That’s $100,000 every month.
And now let’s assume that at the end of the year, you have $200,000 in unpaid invoices in your ledger. That’s your “accounts receivable” at year-end.
Intuitively, you can see that 2 months worth of turnover which equates to approx 60 days has not yet been received by the company.
The simple formula is:
(Accounts Receivables at the end of the period) / (Gross revenues over the period) * (Number of days in the period)
In our previous example that would be ($200,000)/($1,200,000)*(365)=61 days
It’s very easy to compute
You can use this formula to get a quick overview of your DSO, or any company with public accounts. (Tip: check your competitors!)
The formula depends on the time window you use for the calculation. If you have a seasonal business, calculating the DSO across different periods of time (3, 6, 12 months) would give you different numbers and results that are difficult to analyse.
2/ The countback method for calculating DSO
The countback method is more accurate, and it’s widely used by finance professionals. But unfortunately, it does not use a ready-made formula like the previous one.
The idea of the countback method is moving backwards in time, by subtracting the revenues posted each month against the initial stock of accounts receivables you have, until there’s no more left. Same idea as the previous method, but more granular. It's also known as absorbing the sales balance. Let’s look into an example.
Let’s assume we’re on 30 November 30th 2020 and we’d like to calculate our DSO.
We have $2,500 of unpaid invoices (receivables) on that day and the monthly revenues for the previous month were as reported in the table below:
Step 1: As of November 30, the amount outstanding was $2,500. Because we have more receivables ($2500) than turnover ($1200) for November, we start by subtracting $1,200 recorded in revenues for the month. We move back to 31st of October with: - A stock of “counted back” receivables decreasing to $2,500 - $1,200 = $1,300. + 30 days DSO contribution (the whole month of November)
Step 2: We’re back on 31 October. There’s still more receivables ($1,300) than revenues for the month ($800). Same process as before. We move back to September 30 with - A stock of receivables decreasing to $1,300 - $800 = $500 + 31 days DSO contribution (the whole month of October)
Step 3: We’re back on 30 September. This time, the revenues for the month ($700) are higher than the remaining stock of receivables ($500). - Here, we’ll contribute the pro rata of DSO (500/700) * 30 = 21.4 days - There’s no more stock of receivables, we’ve gone through the end of the countback process.
In total, the DSO would then be 30 days + 31 days + 21.4 days = 82.4 days
Here is the table summarising the steps:
If your business is growing, sales’ seasonality is taken into account with this method;
You can calculate your DSO at any given time, without having to wait for the end of the month. It’s better if you’re tracking your DSO and your cash collection on a daily basis.
This method is much more complex to use and requires a sophisticated formula. It’s probably better to find the right tool to compute it for you.
Of note, if we were to use the previous ‘simple’ method on the same numbers, we would have the following results :
($2500)/($1200+$800+$700)*(30+31+30) = 84 days.
You can see that the result is a bit different, and that’s because the countback method takes into account the growing revenues, as opposed to the simple formula.
Whatever method you use, you now have a basis for comparison.
Conclusion: what’s important to know about DSO?
Hopefully, you now understand why you should measure your DSO and how to calculate it.
At Upflow, we’ve spoken to hundreds of CFOs and CEOs, and the reality is that way too often, companies don’t measure their DSO. And that’s a shame, because as they say, “'if you can't measure it, you can't improve it'”
So here is our advice regarding your DSO:
Start measuring it now and compare it to your payment terms. This will give you a sense of how much room for improvement you have.
Don’t focus too much on “how” you calculate it, but rather focus on measuring it consistently and regularly. The best CFOs track DSO on a daily basis and report their average DSO monthly to their board.
Whatever your starting point is, make sure that your DSO moves in the right direction. Down. Most of the time growing companies tend to focus on revenues and other metrics and forget about the cash collection. By implementing systematic cash collection processes, you will quickly see the effects on your DSO.
By regularly measuring your DSO you at least have a KPI that helps you to track your cash collection efficiency.
Final note, as a CEO, CFO, or Finance professional, if you want to know more about your current and historical DSO, you can just create a free account with us. You will not only uncover your DSO numbers but also discover how Upflow can help you implement systematic cash collection processes for both you and your teams, helping to lower DSO quickly.
We'd love to hear your feedback on your DSO calculations! Drop us a line at [email protected]