DSO: A step-by-step guide to calculating Days Sales Outstanding
DSO or Days Sales Outstanding is a KPI that reflects the time it takes for your invoices to be paid by customers. It’s counted in the number of days between the invoice being issued and the cash arriving in your company’s bank account.
It is a useful number to track for 3 reasons. It helps you:
- Manage your expectations around the payment times & credit sales,
- Create a more accurate cash flow forecast,
- Check the effectiveness of your cash collection process.
A high DSO means that it takes longer for your clients to pay you. Consequently, your company has higher aged debts and less liquidity. This isn’t to be taken lightly: many companies have closed because of poor cash flow.
Although maintaining a low DSO is a sign of an effective cash collection process, it's important that your relationships with customers are prioritized. Focus on rewarding early payments rather than penalizing customers in order to maintain a low DSO. You should concentrate on achieving the Best Possible DSO based on the size of your business and your industry rather than aiming for a low DSO at all costs.
Whether high or low, your Day Sales Outstanding is a KPI that should be tracked by CFOs and CEOs alike.
So, how do you calculate your Days Sales Outstanding?
What is considered a “good” DSO for your industry?
How can you have a better DSO?
Keep reading to find out!
- What is the Days Sales Outstanding Formula?
To calculate your Days Sales Outstanding, you have several options:
- The simple method
- The countback method
- The automated method
- Simple Method of DSO Calculation
We’ll start with the simple one, shall we? This method of calculating your Days Sales Outstanding is simple because it relies on one formula:
DSO = (Your A/R at the end of the period) / (Gross sales over the period) * (Number of Days of the Period)
Let’s say that your sales over a one-year period are $1,000,000 and your Accounts Receivable at the end of the year are $100,000.
Your DSO would be: 100,000 / 1,000,000 * 365 = 36,5 days
It means the average number of days your clients take to pay you is 36.
This is simple enough to calculate for your company (or even your competitors’, if they have public accounts).
The downside is that it doesn’t account for your business specificities: if your company has seasonal peaks, your average accounts receivable won't be relevant or even insightful over the period of a year.
You’d have to choose a different time period (like 3 or 6 months) and then compare all these numbers together - that’s rescinding the simplicity.
That’s why most finance professionals use the second method.
- Countback Method of DSO calculation
The countback method to calculate your Days Sales Outstanding is more complicated but also more accurate.
Instead of taking a whole year or quarter, this method goes back in time month-by-month (that’s why it’s called the countback method).
You need the numbers of your gross sales and your accounts receivable for each month. From there, you have 2 options:
1. Your A/R is superior to your gross sales. In this case, you add the number of days of the month to your DSO. When moving on to the next month, you subtract your monthly gross sales from your accounts receivable.
2. Your gross sales are superior to your Accounts Receivables. Here, you calculate the ratio between your A/R and your gross sales and multiplicate your results by x number of days in the month.
The idea is to do this month-by-month until your gross sales become higher than your accounts receivable. Look at the number of days you’ve accumulated to get there: that’s your DSO.
Let’s make it more concrete with an example:
November: your A/R is superior to your gross sales, so you add 30 days to your DSO count (we start at 0). You then subtract your gross sales from A/R: $12,000 - $4,000 = $8,000, which are reported to your A/R for October.
October: your A/R is still superior to your monthly gross sales, so you add 30 days to your DSO count. That’s 61 days so far. Same as before, you then subtract your gross sales from your A/R: $8,000 - $2,000 = $6,000, which are reported to your A/R for September.
September: this month, your gross sales are superior to your AR. Therefore you won’t be adding the whole month to your DSO, only a ratio of it.
The DSO formula is: Account Receivable of Your Period / Gross Sales *30
In this case: $6,000 / $11,000 * 30 = 16,4.
Add this to the previous DSO calculations from November and October: 61 + 16,4 = 77,4 days.
That’s it! You’ve completed the countback method and 77,4 is your DSO for this period.
Using the countback method to calculate your Days Sales Outstanding is more accurate, but it’s also more complicated to do.
You could do it on a spreadsheet, but it’s tiresome - it takes time and it’s error-prone. That’s why we suggest choosing the 3rd option: automating!
As a CFO, the best option for calculating your DSO is to use the more accurate method (the countback one) but to make it simpler to calculate.
Lucky for us financial professionals: there are some tools that automate the whole process of calculating your DSO. No more human errors or time spent using the countback method using a DSO automation tool!
Finding a tool that automatically calculates your Days Sales Outstanding means you can spend more time actually improving it.
At Upflow for example, we automatically calculate your DSO using the countback method when connecting your account with your invoicing solution. You can then track your DSO from your private dashboard without having to think about calculating it yourself.
Now that you have this number at hand, you might be wondering what’s a good Days Sales Outstanding? As is the case with all metrics, the answer is: it depends!
Different industries have different average DSO.
II. Average DSO by industry
Better than the average - which we all know isn’t that insightful - you’ll find below the median DSO for different industries. This Days Sales Outstanding benchmark will allow you to see where you stand in comparison with your competitors.
This Account Receivable and Days Sales Outstanding Report from 2021 can also give you some interesting data on your A/R performance
Let’s take a moment to remind you that you need to calculate your company’s DSO in order to see where you rank. Regardless of the method, you’re using here, it will help you get an idea of where you stand.
Now that you know where your company stands with your Days Sales Outstanding, you can focus on improving this number.
III. How to reduce and improve DSO
If you have a higher DSO - that is, higher than your industry average - then you’ll want to reduce and improve it. (There is such a thing as a too low DSO but more often than not, you’ll be wanting to reduce this number.)
A lower DSO means a shorter cash conversion cycle, more opportunities to invest, and overall better working capital management.
Here are some ways to reduce and improve your DSO:
- Automate your billing process. Sending and tracking your invoices automatically reduces human errors - which we tend to underestimate. By scheduling automatic reminders, you’ll be able to keep the process under control. This can look like a reminder to your team to send a personalized email to your client or to pick up the phone.
- Maintain positive relationships with customers. In general, keeping regular contact with your customers is a good idea. It's important that managing your DSO doesn't negatively impact your relationship with your customers.
You should consider having a discretionary payment date relative to your relationship with them i.e. more flexibility with long-term customers and bigger accounts. Focusing on rewarding rather than penalizing customers is a good approach. A closer relationship means more loyalty, repeat business, and better feedback over your product or services.
That’s typically the role of Account Executives or Customer Service Manager, whose role isn’t only to close the sale - it’s also to help the company collect the money!
- Offer customers incentives for early payment. An efficient way to reduce your DSO is to offer perks for your clients to do so. It could look like a % discount on said invoice if they pay early, or a discount on their next purchase with you. It could also be a kind of bonus that’s relevant to your business, or even a gift!
III. Limitations of DSO calculation
Tracking your Days Sales Outstanding is primordial in your business. It’s a very important KPI that CEOs and CFOs alike should check daily.
However, like everything, DSO has its limitations:
- Every transaction needs to be linked to an invoice. If a client overpays or a credit sales note is issued, this needs to be linked to an invoice for the calculation of DSO to be accurate.
- Invoice disputes are not excluded. If a client has been disputing an invoice, it’s likely overdue and it will weigh on your DSO month after month.
- Not all invoices weigh the same. DSO doesn’t take into account the importance of the invoice: an invoice for $100 or for $100,000 has the same impact. Focusing on your DSO for bigger invoices will have a bigger impact on your business.
Your Days Sales Outstanding is an important financial KPI that needs to be tracked and reduced.
The way to calculate it is simple: you can use the simple method, the countback method, or - the best of both worlds - use a tool to automate the calculation of the countback method.
Once you have compared your Days Sales Outstanding with other businesses in your industry, you should focus on improving this number. This will make a difference to your financial statements.
This can be done by automating your billing process, making sure you have a good relationship with your customers, and offering some incentives to encourage them to pay early.
One thing is sure: your DSO will make or break your business, so pay close attention to it!