The longer a company can postpone the payment of an invoice, the less it burdens its liquidity. When you discover past-due accounts, take action to remind clients of their overdue payments. Reaching out about past due payments can be challenging and even a little uncomfortable, particularly if your ability to pay your business’s bills depends on incoming cash flow from clients. Automating the accounts receivable process is simple when you use accounting software that integrates with your payment system and business bank account. On the other hand, DSO decreasing means the company is becoming more efficient at cash collection and thus has more free cash flows (FCFs).
Looking at both ratios, BWW seems well positioned within the industry, and a potential investor or lender may be more apt to contribute financially to the organization with this continued positive trend. Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts. But again, this is rather rare in practice since not all companies disclose the sales made on credit and the timing, which is important because DSO does not provide much insight as a standalone metric.
In contrast, a lower number of times indicates that receivables are collected at a slower rate. A slower collection rate could signal that lending terms are too lenient; management might consider tightening lending opportunities and more aggressively pursuing outstanding debt. The lower turnover also shows that the company has cash tied up in receivable longer, thus hindering its ability to reinvest this cash in other current projects. The determination of a high or low turnover rate really depends on the standards of the company’s industry. Days sales outstanding is important because it represents how efficiently a business collects payments, which can impact profitability.
Customer satisfaction might be declining, or the salespeople may be offering longer terms of payment to drive increased sales. Perhaps the company may be allowing customers with poor credit to make purchases on credit. In general, small businesses rely more heavily on steady cash flow than large, diversified companies. When customers pay for a service in advance, it is most advantageous for a company. To make this more attractive to customers, you can give them cash discounts or other rebates. Even if this reduces profits somewhat, it avoids creating a cash shortage due to delayed revenues.
The longer the payment period of an invoice, the longer the customer can take to pay. It is important that the values for both Average accounts receivable and Revenue are based on 90 days, otherwise the result for Accounts receivable days will be incorrect. Many clients may be accustomed to making payments using a certain method, which can create friction when it’s time for them to pay their bills.
Using the DSO formula, you find it takes an average of 60 days to collect your invoices. Most business owners compare figures quarterly or annually, not over prior time periods. You can see from the example in the previous section that with a higher value of average accounts receivable or a smaller value for revenue, the result for accounts receivable days becomes larger. This means that the higher the average receivable amount within a period with constant revenue, the longer the company has to wait for payment.
To compute DSO, divide the average accounts receivable during a given period by the total value of credit sales during the same period, and then multiply the result by the number of days in the period being measured. Lost revenue may also result in cash flow problems that may lead you to seek outside financing. If you can’t pay your monthly operational costs, your interest payments may increase your cash burden. And if you send the account to a collection agency, they may collect a percentage of the balance. The calculation of days sales outstanding (DSO) involves dividing the accounts receivable balance by the revenue for the period, which is then multiplied by 365 days.
Other metrics businesses can use to assess the effectiveness of their collections include the cash conversion cycle and accounts receivable turnover ratio. In accountancy, days sales outstanding (also called DSO and days receivables) is a calculation used by a company to estimate the size of their outstanding accounts receivable. It measures this size not in units of currency, but in average sales days. It is possible that within the average accounts receivable balances there are some receivables that are 120 days or more past due. These could easily be buried in the average if most customers are remitting the amounts by the dates the receivables are due.
Days sales outstanding (DSO) is a measure of the average number of days that it takes a company to collect payment for a sale. The latter indicate how long it takes on average for a company to pay its own invoices (e.g. to its suppliers). To understand the effectiveness of your accounts receivables process, analyze individual DSO values, and review trends in DSOs over time. Instead, forecast your business’s cash flow to plan for seasonal changes.
A high DSO value illustrates a company is experiencing a hard time when converting credit sales to cash. But, depending on the type of business and the financial structure it maintains, a company with a large capitalization may not view a DSO of 60 as a serious issue. Generally, when looking at a given company’s cash flow, it is helpful to track that company’s DSO over time to determine if its DSO is trending up or down or if there are patterns in the company’s cash flow history. Looking at a DSO value for a company for a single period can provide a good benchmark for quickly assessing a company’s cash flow. The ratio to determine number of days’ sales in receivables is as follows. Once a service has been rendered (e.g. goods delivered to the customer), it is advisable to create an invoice immediately and send it to the customer.
Of interest when analyzing the performance of a company is the trend in DSO. If DSO is getting longer, accounts receivable is increasing or average sales per day are decreasing. Similarly, a decrease in average sales per day could indicate the need for more sales staff or better utilization.
While this may not be welcome news, it does not indicate a change in the balance of sales and receivables, and therefore will not affect DSO. Accounts receivable refers to the outstanding balance of accounts receivable at a point in time here whereas average sales per day is the mean sales computed over some period of time. This can be annual as in the formula above, or it can be any period of time considered useful to the company. Because this is an average general KPI, though, choosing a time period that’s too low may introduce undesirable artifacts in the data.
Fast credit collectability decreases problems related to paying operational expenses, and any excess money that is collected can be reinvested right away to increase future earnings. Net credit sales are sales made on credit only; cash sales are not included because they do not produce receivables. However, many companies do not report credit sales separate from cash sales, so “net sales” may be substituted for “net credit sales” in this case. Beginning and ending accounts receivable refer to the beginning and ending balances in accounts receivable for the period. The beginning accounts receivable balance is the same figure as the ending accounts receivable balance from the prior period.
Also, cash sales are not included in the computation because they are considered a zero DSO – representing no time waiting from the sale date to receipt of cash. George Michael International Limited reported a sales revenue for November 2016 amounting to $2.5 million, out of which $1.5 million are credit sales, and the remaining $1 million is cash sales. In many businesses, the days sales outstanding number can be a valuable indicator of the efficiency of the business and the quality of its cash flow.
On the other hand, a low DSO is more favorable to a company’s collection process. Customers are either paying on time to avail of discounts, or the company is very strict on its credit policy, which may negatively affect sales performance. However, having a low DSO for small to medium-sized businesses generally carries considerable benefits.
The debt collections experts at Atradius suggest that tracking DSO over time also creates an incentive for the payments department to stay on top of unpaid invoices. Needless to say, a small business can use its days sales outstanding number to identify and flag customers that are weighing it down by not paying promptly. Another receivables ratio one must consider is the number of days’ sales in receivables ratio. This ratio is similar to accounts receivable turnover in that it shows the expected days it will take to convert accounts receivable into cash. The reflected outcome is in number of days, rather than in number of times.
The accounts receivable (A/R) line item on the balance sheet represents the amount of cash owed to a company for products/services “earned” (i.e., delivered) under accrual accounting standards but paid for using credit. However, for a small-scale business, a high DSO is a concerning matter because it may cause what is bookkeeping cash flow problems. Smaller businesses typically rely on the quick collection of receivables to make payments for operational expenses, such as salaries, utilities, and other inherent expenses. They may struggle for cash to pay these expenses from time to time if the DSO continues to be at a high value.