What does Days Sales Outstanding mean and how do you calculate it?
The Days Sales Outstanding value indicates the length of time customers pay their bill on average. For companies, this value is of great importance because it has a direct influence on liquidity. Read here how to calculate, interpret and improve the Days Sales Outstanding.
Days sales outstanding is also abbreviated as DSO. It is a key figure that indicates how long it takes on average for a customer to pay an open invoice to a company.
The DSO value is important in liquidity management because if the term is very long, it puts a strain on the company's liquidity because customers take a long time to pay their invoices.
For the company, this means a lack of income, which ultimately pushes liquidity down. In the worst case, the company can fall into arrears because it does not have enough cash to pay its own bills.
The following formula is used to calculate the Days Sales Outstanding:
Days Sales Outstanding = Average Accounts Receivable / Revenue x 365 days
Average Accounts Receivable is the amount of accounts receivable submitted by the company within 365 days. This is set in relation to the turnover generated in the same period.
It is also possible to relate the DSO value to another time period, for example to 90 days. The only important thing is that both the number of average claims and the turnover always refer to the same period, otherwise the DSO value is not correct.
A company had an accounts receivable balance of £200,000 in 2021. During this period, turnover was £1,000,000.
Now we can calculate the Days Sales Outstanding: DSO = £200,000 / £1,000,000 x 365 = 73 days
So on average it takes 73 days for customers to pay their bill.
There is another way to calculate DSO: the countback method. It is a little more complicated than the formula presented above, but it provides a more accurate result.
Instead of looking at a quarter or a whole year and calculating the averages, the countback method goes back month by month. This requires the gross turnover from sales and the amount of receivables from each month.
One then compares the gross turnover of a month with the amount of receivables from the same month. Two results are possible:
Amount of receivables greater than gross turnover: The number of days per month is added to the DSO value.
Gross turnover is greater than the amount of receivables: Calculate Average Accounts Receivable / Revenue x number of days in this month.
The turnover and amount of receivables look like this for a company in three consecutive months:
|Month||Revenue||Average Accounts Receivable||DSO|
|April (30 days)||£5,000||£7,000||30|
|May (31 days)||£3,000||£9,000||61|
|June 30 Days||£7,000||£5,000||82.42|
In April, the receivables are higher than the turnover: we add up the DSO days and get a value of 30 because we start at 0.
In May, receivables are also higher than turnover: we add the number of days of the month to the previous DSO value: 30 + 31 = 61
In June, turnover is higher than receivables: We calculate according to the DSO formula: DSO = £5,000 / £7,000 x 30 = 21.42 days
We add this value to the existing DSO value, which is now the final result: 61 + 21.42 = 82.42
You can see from the above examples that a small DSO value is favourable for a company. The shorter the period in which customers pay their bills, the faster the company receives its revenues and the better it can ensure its liquidity.
The DSO value varies greatly from industry to industry. E-commerce and retail companies typically have low Days Sales Outstanding, often in the range of 7 to 30 days. In manufacturing industries, where customers are often given longer payment terms, the DSO value can be 60 days or even higher.
The Days Sales Outstanding can often be improved by very simple measures. This is necessary at the latest if you often have liquidity problems due to a high DSO value because you do not have enough cash available to pay your own invoices on time.
By giving your customers shorter payment terms, you give them less time to pay their bills. The result is that you get your money faster. So if payment terms are already very generous, this can be a very easy way to improve your Days Sales Outstanding value.
You can also divide your customers into different groups, for each of which you set different payment terms: Customers who always pay on time get a longer payment period than customers who repeatedly attract attention because of their poor payment behaviour. This can also be used to push the DSO value down.
Some companies wait until the end of the month to send out their invoices, even if a service was already provided at the beginning of the month. This unnecessarily prolongs the payment period and increases the DSO value.
After a service has been rendered, it therefore makes sense to send an invoice to the customer immediately. Then, in the best case, you only wait for your money as long as the payment period runs.
A company can sell its outstanding receivables to a factoring service provider and then receive its money immediately for a fee. This is particularly advantageous for companies that often have to deal with customers who pay their invoices very late. Even if some profit is lost due to the factoring costs, liquidity is maintained and the days sales outstanding are shortened.