Anyone who has ever dealt with accounts receivable directly - or even tangentially - has heard of DSO. Even if you don’t know what it stands for (that’s days sales outstanding), you’re probably familiar enough to know that it’s important.
That’s because it is. If there’s a northstar metric for an A/R operation, it’s likely DSO. Why is that? What makes it so important? Here, we’ll give a thorough definition of DSO, how it’s calculated, why it’s so important and what you can do to improve it.
So, it stands for days sales outstanding, but what does that really mean. First of all, unlike most financial metrics, it’s not measured in dollars. It’s a measurement of time - days specifically.
It’s the average number of days it takes a company to collect payment on a sale. The short definition would be how long your customers take to pay you. It’s a sound way of determining if you’re being too lax in collecting payments, thus impacting your liquidity, or if you’re too rigid, could dampen sales.
There are several key metrics by which you can measure your A/R operation. However, DSO is often viewed as the one that matters most.
DSO can be easily calculated with this formula:
(Accounts Receivable/Total Credit Sales) X Number of Days
“Number of Days” can be any time period, such as a month or a year.
Note that cash sales should not be considered in this calculation, as those transactions have an inherent DSO of 0.
A higher number shows that you’re struggling to close out transactions, which may be hurting your business growth. A lower number would seemingly be desirable, but too low of a number may reflect that your payment process lacks flexibility. That can ultimately cost your sales.
Why is DSO so Important?
It’s usually used to measure the effectiveness of an A/R operation, but can also be used to look at things like a company’s cash flow or even customer satisfaction. It’s a highly effective metric that can be used for a variety of applications.
It can be an early harbinger of cash flow issues. Your company must pay its own bills as well, likely on a regular schedule. A steady increase in your DSO means you may be unable to pay your regular expenses or make capital improvements. For example, it would be difficult to increase headcount if you can’t ensure that you’ll have the funds on hand to take on that new expense.
With customers, an increasing DSO may show a decrease in satisfaction. If your product isn’t providing a meaningful impact to a customer, they’ll be less likely to pay on time to avoid a suspension of service.
How do you Improve DSO?
The most important thing you can do is make your A/R operation efficient and make it easy for customers to pay. You may also look at providing incentives, increasing your dunning and chasing efforts or even making simple changes to your invoice templates.
Automating your accounts receivable is the most effective thing you can do. It will make you more responsive to customer needs and allow you to easily update your strategies. If you want to offer incentives for early payments or send chasing letters at 30 days instead of 45, an automated operation is the quickest option.
Additionally, modern customers are used to being able to make payments quickly and easily. Make sure your experience is keeping up with your competitors by allowing your customers to access their own payment portal and pay through a variety of methods. Remove as many barriers as you can.
For many companies, DSO is the gold standard of accounts receivable metrics. It allows you to understand this part of your business better than most other equations. It may or may not be the most important to your business, but you should at the very least be actively tracking it and trying to find the ideal number.