CFO, CEO, why you should track your DSO, and how to measure it
We often hear that the top-performing companies manage their working capital efficiently, and have strong control over their cash flows. But what does it mean? From a finance perspective, simply put, businesses have cash inflows and cash outflows. Managing your working capital efficiently is making sure that at an operational level, your business is above the floating line, i.e. cash collection for customers cover your cash outflow to suppliers. Ideally, you not only stay above the floating line but optimise these cash flows, collecting cash faster than spending it!
Today, we'll focus on a key item of cash inflows: measuring how your business gets paid by customers. We'll see 1/ what is a DSO 2/ why it's important for your business and 3/ how to measure your DSO.
What is DSO?
DSO stands for "Days Sales Outstanding". In simple words, it’s the time it takes to your business to get paid by your users. It’s usually measured in a number of days.
DSO is the average number of days for your business between 1/ invoice issuance, and 2/payment received. For online businesses, that’s usually 0 days, as you’re invoiced 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 issues for suppliers.
What does DSO number mean and why it’s important?
You can think of your DSO compared to your average payment terms:
- High DSO: 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 supplier 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 invoice are much more likely to never get paid…. Don’t get there.
- Low DSO: If your DSO is approximately around 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. 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, usually a good proxy for the quality of your relationship with your Customers. It will also help you with your financial planning, as a more realistic estimate of your future cash collection.
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 for that. Remember that when your Customer receives your invoice, it's not a guarantee for you to 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;
- The invoice might be sent to the wrong person or lacks some required data 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;
- 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, Customers would not proactively reach out to their suppliers when such a problem occurs. That's why B2B merchants need to be proactive on 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 good or bad cash collection for a business.
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.
But it can get tricky:
- It should be weighted against the value of the invoices (you probably wouldn’t care as much as for a small invoice paid late than a really large one)
- If you have a seasonal business with peaks of invoicing, you’re likely to have temporarily more unpaid invoices, and you should take it into account.
- At any given time, you should take into account “opened” invoices, which are invoices you’ve issued but not yet collected. Obvious, but if invoices are already overdue, they will be paid late or never get paid, so you should definitely take them into account when reporting your DSO.
Let’s see two methods to calculate your DSO addressing those points.
1/ A simple method for 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 at the end of the year, you have $200,000 unpaid invoices in your ledger. That’s your “accounts receivable” at year-end.
Intuitively, you can see that 2 months of turnover are out of the business, which is approx 60 days.
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, different time frames (3, 6, 12 months) would give you different numbers and results are difficult to analyse.
2/ The countback method for 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. Let’s look into an example.
Let’s assume we’re 30 November 2020 and we’d like to compute the 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 prorata 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 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 with DSO?
Hopefully, you now understand why you should measure your DSO and how to compute 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, “you can’t measure progress without a target”. Let’s build this target together.
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 compute it, but rather focus on measuring it consistently and regularly. The best CFOs track DSO on a daily basis and report it monthly to their board.
- Whatever your starting point is, make sure your DSO moves in the right direction. Down. Most of the time growing companies tend to focus on revenues and forget about cash collection. By implementing systematic cash collection processes, you will quickly see the effects on your DSO.
With a regular DSO measurement, at least now you have a KPI to track your cash collection efficiency.
Final note, as a CEO, CFO, or Finance professional, if you want to know your current and historical DSO, you can just create a free account with us. You will not only see your DSO numbers but also discover how Upflow can help you implement systematic cash collection processes for you and your teams, to bring your DSO down quickly.
We'd love to hear your feedback on your DSO calculations! Drop us a line at [email protected]