There are many terms you can offer to clients, and if you find certain customers are consistently behind on payments, it may help to shorten your payment terms. When the cash your clients owe your business sits in their bank accounts, it negatively affects your finances in a few ways. If your business has a high DSO, consider evaluating your credit policies, including to whom you extend credit. If your DSO begins to climb, it may mean more of your cash is tied up in accounts receivable. Now, we can project A/R for the forecast period, which we’ll accomplish by dividing the carried-forward DSO assumption (55 days) by 365 days and then multiply it by the revenue for each future period.
Some companies wait until the end of the month to issue their invoices, thereby pushing their revenues further into the future and, in the worst case, getting themselves into payment difficulties. The value for accounts receivable days can be shortened in various ways. Depending on what measures the company has already implemented and what the liquidity situation looks like at the moment and in the near future, further steps can be examined. Accounts receivable days is an important key figure for companies, as it has an influence on the liquidity situation. Here we show you how to calculate, interpret and improve accounts receivable days. It suggests how efficient the company’s collections department is, and the degree to which the company is maintaining customer satisfaction.
It helps to know the number of days it takes to go through the accounts receivable collection cycle so a company can plan its debt repayments; this receivables ratio also signals how efficient its collection procedures are. As with the accounts receivable turnover ratio, there are positive and negative elements with a smaller and larger amount of days; in general, the fewer number of collection days on accounts receivable, the better. American Superconductor Corporation specializes in the production and service of energy-efficient wind turbine systems, as well as energy grid construction solutions. On the company’s 2018–2019 financial statements, the accounts receivable turnover ratio is approximately 6.32 times, and the number of day’s sales in receivables ratio is approximately 58 days. This site providing American Superconductor Corporation’s current financial statements is available for review. Days sales outstanding can vary from month to month, and over the course of a year with a company’s seasonal business cycle.
Another way to improve your cash flow is to require a deposit before starting work, or to agree payment terms that require progress payments. Both upfront deposits and progress payments, which are delivered based on the completion of a specific part of the work you’re doing for a client, can help you get paid faster for your work. Similarly to decisions about payment terms, you can also make decisions about the credit requirements of your clients. It’s often easier to decide to adjust payment terms based on a client’s credit history before completing any work than it is to deal with collecting from a late-paying client after you’ve delivered the work. A client’s credit history may give you insight on how to adjust your payment terms and credit policies when working with them.
As we have seen, the smaller the value for accounts receivable days, the better for liquidity. Depending on the industry, however, the key figures for accounts receivable days differ drastically. In industrial companies, where longer payment terms are common, the values for accounts receivable days can be 60 days or even more. Your accounts receivable (A/R) is all outstanding payments owed to your company, and can be found by reviewing your balance sheet and income statement. The days-sales-outstanding formula divides accounts receivable by total credit sales, multiplied by a number of days in a measurement period. In effect, determining the average length of time that a company’s outstanding balances are carried in receivables can reveal a great deal about the nature of the company’s cash flow.
It is important to remember that the formula for calculating DSO only accounts for credit sales. While cash sales may be considered to have a DSO of 0, they are not factored into DSO calculations. If they were factored into the calculation, they would decrease the DSO, and companies with a high proportion of cash sales would have lower DSOs than those with a high proportion of credit sales. If a company wants to find out whether its values are too high or too low, only a comparison with companies from the same industry is recommended. This can then be used to assess how one compares to the competition and whether it is necessary to take measures to reduce the accounts receivable days.
Days sales outstanding tends to increase as a company becomes less risk averse. Higher days sales outstanding can also be an indication of inadequate analysis of applicants for open account credit terms. An increase in DSO can result in cash flow problems, and may result in a decision to increase the creditor company’s bad debt reserve. Given the above data, the DSO totaled 16, meaning it takes an average of 16 days before receivables are collected. Generally, a DSO below 45 is considered low, but what qualifies as high or low also depends on the type of business.
A high DSO number can indicate that the cash flow of the business is not ideal. If the number is climbing, there may be something wrong in the collections department, or the company may be selling to customers with less than optimal credit. Divide the total number of accounts receivable during a given period by the total dollar value of credit sales during the same period, then multiply the result by the number of days in the period being measured.
Over the course of the projection period, the company’s management team expects revenue to grow at a constant rate of 10.0% each year. That said, an increase in A/R represents an outflow of cash, whereas a decrease in A/R is a cash inflow since it means the company has been paid and thus has more liquidity (cash on hand). Upgrading to a paid membership gives you access to our extensive collection of plug-and-play Templates designed to power your performance—as well as CFI’s full course catalog and accredited Certification Programs.
More specifically, the customers have more time after receiving the product to actually pay for it. For the company, this means that it has to wait longer for its revenues, while it has already gone into pre-financing by providing the service to the customer and must continue to cover its running costs. The first step to projecting accounts receivable is to calculate the historical DSO. Thus, it is critical to not only diligence industry peers (and the nature of the product/service sold) but the customer-buyer relationship.
This quick cash collection may be viewed as a positive occurrence, because liquidity improves, and the company may reinvest in its business sooner when the value of the dollar has more buying power (time value of money). The higher number of times may also be a negative occurrence, signaling that credit extension terms are too tight, and it may exclude qualified consumers from purchasing. Excluding these customers means that they may take their business to a competitor, thus reducing potential sales. If it takes longer for a company to collect on outstanding receivables, this means it may not be able to meet its current obligations.
For this clothing retailer, it is probably necessary to change its collection methods, as confirmed by the DSO lagging behind that of competitors. But the more common approach is to use the ending balance for simplicity, as the difference in methodology rarely has a material impact on the B/S forecast. Harold Averkamp (CPA, MBA) has worked as a university accounting instructor, accountant, and consultant for more than 25 years.
If the number gets too high, it could even disrupt the normal operations of the business, causing its own outstanding payments to be delayed. DSO is not particularly useful in comparing companies with significant differences in the proportion of expenses or assets sales that are made on credit. The DSO of a company with a low proportion of credit sales does not indicate much about that company’s cash flow. Comparing such companies with those that have a high proportion of credit sales also says little.
A company’s days sales outstanding (DSO) is the average number of days it takes the business to collect payment over a period following a sale. Days sales outstanding is also sometimes referred to as “days sales in receivable”. Days sales outstanding is considered an important tool in measuring liquidity. In some sense it measures the balance between a company’s sales efforts and collection efforts. If sales decreases in isolation DSO will increase indicating that may run into cash flow problems in future when the sales dip flows through the collection cycle. If sales decreases proportionally to accounts receivable, DSO will not increase.
Analyzing DSO can help you pinpoint issues in your accounts receivable process and help forecast cash flow. Tracking DSO over time can help you identify trends that might inform your cash flow forecast. Thus, accounts receivable days play an important role in liquidity management. If it takes a long time for customers to pay their invoices, the company may experience a liquidity bottleneck and get into payment difficulties through no fault of its own. For this reason, companies strive to keep the value of accounts receivable days as low as possible.
Stakeholders, such as investors, lenders, and management, look to financial statement data to make informed decisions about a company’s financial position. They will look at each statement—as well as ratio analysis—for trends, industry comparisons, and past performance to help make financing determinations. Because you are reviewing companies for quick debt collection, as well as credit extension to boost sales, you would consider receivables ratios to guide your decision. Receivables ratios show company performance in relation to current debt collection, as well as credit policy effect on sales growth. This ratio determines how many times (i.e., how often) accounts receivable are collected during an operating period and converted to cash (see Figure 9.3). A higher number of times indicates that receivables are collected quickly.
DSO may vary consistently on a monthly basis, particularly if the company’s product is seasonal. If a company has a volatile DSO, this may be cause for concern, but if its DSO regularly dips during a particular season each year, it could be no reason to worry. We’ll now move to a modeling exercise, which you can access by filling out the form below.