Days Sales Outstanding (DSO) is important in the tech industry as companies often operate on a subscription or recurring revenue model, where customers make regular payments over an extended period. This creates a need for efficient cash flow management and timely collection of receivables. The tech industry is known for its fast-paced environment, with rapid product innovation and short product cycles. This requires companies to invest heavily in research and development, often relying on consistent cash flow to fund these activities. Monitoring and optimizing DSO becomes crucial to ensure a steady influx of cash and maintain financial stability.
What is Days Sales Outstanding?
Abbreviated as DSO, the Days Sales Outstanding metric is used to show the average number of days it takes to collect payment after the company has made a sale. This metric is usually determined for a yearly, quarterly, or monthly period.
In short, the Days Sales Outstanding is a financial ratio that’s mean to illustrate/ show if the accounts receivables of a company are well managed. By analyzing this metric, a company/ business can round up the average number of days it takes for their customers to pay invoices.
The Basics of Days Sales Outstanding
Given the previously mentioned, we can safely assume that a company with a high Days Sales Outstanding ratio either has a customer base with credit problems or that the company itself is deficient when it comes to its collection’s activity.
On the other hand, a low ratio is not that good as well – for example, a low ratio can mean that the credit policy of the company is too rigorous, a fact that can later hamper the sales.
The Days Sales Outstanding is also used to measure the liquidity of a company/ business. A company with an increasing Days Sales Outstanding ratio means that the company is on its way to becoming less and less risk-averse. A high Days Sales Outstanding ratio can also mean that the analysis of the applicants for the open account credit terms has been done inadequately.
The Formula of Days Sales Outstanding
In order to calculate the Days Sales Outstanding metric, we can use two different formulas. For the first formula, we have to divide the accounts receivable by the total credit sales and then multiply the end result with the number of days for which we wish to know the Days Sales Outstanding Ratio.
Or, we could make things a little bit more complicated and first divide the total credit sales by the number of days and then divide the accounts receivable by the end result of the previous equation.
We all know the time value of money principle – basically, time is money and time spent doing nothing means lost money. Therefore, in the case of Days Sales Outstanding, where a company is waiting to receive money from its customers, as payment for certain products or services, the longer the time, the more money goes down the drain, so to say.
What Is the Formula of the Days’ Sales Outstanding Calculation?
The days’ sales outstanding calculation = (accounts receivables/net credit sales) x 365. As you can see, the ratio is usually calculated at year-end. Afterward, it is multiplied by 365 days.
Similar to other crucial information, you can find the accounts receivables information on the year-end balance sheet. Nevertheless, in regards to the net credit sales, on the income statement, these are usually reported separately from the gross sales. Concurrently, we should mention that the credit sale figure, in most situations, has to be provided by the company.
Another means in which you could calculate this formula is by utilizing the accounts receivables turnover ratio instead.
In-Depth Analysis of the Calculation
In the simplest terms, the days’ sales calculation formula is widely used by both investors and creditors. And it makes sense for investors and creditors to be interested in how efficient a company is at collecting cash from customers. Evidently, increasing the number of sales has no use if no money is collected. Therefore, this ratio outlines the accurate number of days it takes a company to transform sales into cash.
A lower ratio is more favorable than a higher ratio. This would indicate that the accounts receivables are favorable, therefore, they won’t be written off as bad debt.
On the other hand, a higher ratio displays that the company might be coping with poor collection procedures. In other words, customers are less likely to pay or aren’t willing to pay for their purchases.
Let’s Look at an Example
In order to have a clearer outlook on the matter, let’s see an example. So, let’s say that a company sells inventory to customers agreeing that the payment can be done within 30 days. Some of the customers might be prompt in making payments, while others might be delinquent.
As a result, the financial statements of this company at the end of the year will be the following:
Accounts receivables = $15,000
Net credit sales = $175,000
The calculation formula will be:
($15,000/$175,000) x 365 = 31 days
31 is a decent ratio considering that the company aims at collecting cash in approximately 30 days.
In summary, we believe that this article addressed the main specifications of this topic. Should you have other questions, do let us know!
10 Best Practices for Managing Days Sales Outstanding (DSO)
1. Clear and consistent credit policies
Clearly define payment terms, credit limits, and consequences for late or non-payment.
2. Robust credit assessment
Verify the creditworthiness of new customers by checking credit reports, references, and conducting financial analysis. This helps minimize the risk of late payments or defaults.
3. Effective invoicing processes
Ensure invoices are issued promptly and accurately, with details such as payment due dates, invoice numbers, and clear instructions for payment. Use electronic invoicing to expedite delivery and reduce errors.
4. Timely proactive collections
Monitor aging accounts receivable regularly and initiate collection efforts as soon as payments become overdue by using automated reminders and follow-up procedures to prompt customers for payment.
5. Streamlined payment methods
Offer convenient and diverse payment options to customers like electronic payments, such as credit cards or online transfers, to facilitate faster and easier payment processing.
6. Customer relationship management
Regularly engage with customers to address any concerns or issues that may be delaying payment. Promptly resolve disputes or discrepancies to ensure smooth payment transactions.
7. Efficient cash application
Streamline the cash application process by implementing automated reconciliation systems to ensure timely and accurate recording of payments.
8. Collections performance measurement
Continuously monitoring and measuring collections performance using key metrics such as DSO, collection effectiveness index (CEI), and aging analysis with regular reviews helps identify trends, improvement areas, and potential bottlenecks.
9. Training and development
Invest in training and development programs for staff involved in credit and collections to equip them with the necessary skills and knowledge to manage accounts receivable effectively, negotiate with customers, and handle difficult situations.
10. Utilize technology solutions
Leverage technology solutions like accounting software and customer relationship management (CRM) systems to automate and streamline accounts receivable processes.
Each practice builds a robust credit management framework, strengthens customer relationships, and ensures timely payments for sustained business growth.
The Bottom Line
We all know the time value of money principle – basically, time is money and time spent doing nothing means lost money. Therefore, in the case of Days Sales Outstanding, where a company is waiting to receive money from its customers, as payment for certain products or services, the longer the time, the more money goes down the drain, so to say.
Of course, the money eventually gets to the company – but what matters is the availability of money and the time they should be available in. For example, if someone is taking too long to pay a certain sum, the company can’t rely on that sum when let’s say, it makes a bid on a certain patent or item.
In short, the company can’t rely on the money they theoretically already have to pay for other things or to just use them in diverse operations.
Moreover, cash flow problems within the company can be avoided by selling fewer products/ services to customers on credit. Naturally, if a product is bought on credit, the company will have the money for it in a longer period.
In the end, by calculating the Days Sales Outstanding, the company can get a great overview of its internal cash flow and any potential issues.