Days sales outstanding (DSO) measures the average number of days it takes a business to collect payment from their customers. Similar to the accounts receivable turnover ratio, the DSO ratio can be measured monthly, quarterly, or annually, depending on the volume of credit sales your company has.
Learn how to calculate the DSO for your business and what the results of that calculation mean.
Overview: What is days sales outstanding (DSO)?
Sales may be up for your business, but if you’re not collecting payment on those sales, your cash flow suffers, and could ultimately put you out of business.
Days sales outstanding is an accounting ratio you can easily calculate to determine how many days it’s taking your customers to pay you. For newer businesses, or businesses that have limited cash flow, not tracking your DSO can have serious repercussions, including bankruptcy.
To understand the significance of DSO, let’s review some familiar accounting terms.
• Accounts receivable: Accounts receivable is the money owed to you by your customers for the goods and services they have already received. Your accounts receivable balance is recorded as an asset on your balance sheet.
• Cash sale: A cash sale is a payment that is made at the time goods and services are received. Counter to its name, a cash sale does not mean payment in cash (although it can), and it also refers to any form of acceptable payment such as check, credit card, or money order that is immediately made.
• Credit sale: A credit sale is a purchase made by a customer that does not require immediate payment. When a credit sale is made, the customer is typically provided with payment terms indicating when the payment is due.
• Payment terms: Before offering credit to your customers, be sure that they’ve been provided with payment terms. Payment terms specify important details such as any discount for early payment and when the payment is due.
All of the information you need to calculate your DSO is available from the financial statements produced by your accounting software application. If you’re still using a manual accounting system, you’ll need to total various ledgers and manually create financial statements before you’re able to calculate DSO.
The formula for days sales outstanding
The formula for calculating days sales outstanding is:
Accounts receivable ÷ Total Credit Sales x Number of Days in Period
If you’re ready to calculate the days sales outstanding for your business, just follow the steps outlined below.
How to calculate days sales outstanding
To figure out your days sales outstanding, you’ll need to pull information from an aged accounts receivable report or a balance sheet. Once this information has been gathered, you’re ready to calculate your DSO.
1. Determine the period to cover
It’s up to you to determine the period you want to cover when calculating DSO. Smaller businesses may find it more useful to calculate DSO quarterly, although businesses that frequently sell on credit should do a DSO calculation monthly.
2. Calculate beginning accounts receivable total for the period
This information can be obtained from a balance sheet that is run as of the first date of the period you’ll be examining. For instance, if you wish to calculate DSO for the first quarter of 2020, you’d run a balance sheet as of Jan. 1, 2020, to locate your beginning accounts receivable balance.
3. Calculate ending accounts receivable total for the period
Obtaining your ending accounts receivable balance is done in the same manner, only this time you’ll run a balance sheet report as of March 31, 2020.
4. Determine average accounts receivable for the period
This is an easy calculation. Just take your beginning accounts receivable balance and your ending accounts receivable balance for the time frame you selected.
For example, if your Jan. 1, 2020, accounts receivable balance was $27,000 and your ending accounts receivable balance was $31,000, you can calculate your average balance like this:
($27,000 + $31,000) ÷ 2 = $29,000
Now you know that $29,000 was your average accounts receivable balance for the first quarter.
5. Calculate total credit sales for the period
This calculation can get a bit tricky if you don’t keep track of cash sales separately. If you do, all you need to do is locate your total sales for the period. Be sure and subtract any returns or adjustments, and if you don’t track cash sales automatically, you’ll have to subtract those as well.
For example, if you had credit sales of $57,000 for the first quarter of 2020, with returns totaling $1,500, your total sales for the period would be $55,500.
6. Determine the number of days in the specified period
If you’re calculating DSO for the month, you use the number of days in the month. In our example, we’re calculating DSO for the quarter, so we’ll need to add together the number of days in each month.
• January: 31 days
• February: 29 days (leap year)
• March: 31 days
So, the total days for the first quarter would be 91.
7. Calculate DSO
With all the information gathered, you’re now ready to calculate days sales outstanding using the DSO formula.
($29,000 average accounts receivable ÷ $55,500 credit sales) x 91 days = 48 days
You now know that it takes your business 48 days on average to collect payment on an invoice. But what do those results mean?
In general terms, a DSO of less than 45 is considered good, but this can vary between industries. For example, a manufacturer selling heavy equipment is more likely to have a higher DSO than a service business.
If your DSO comes back fairly high, there are ways you can lower it, including the following.
• Encouraging payment upfront: If you ask for payment at the time of purchase, you may be surprised by how many of your customers oblige.
• Make it easier for customers to pay: Still requiring customers to write and mail a check? Offering your customers multiple ways to pay can lead to a much faster payment turnaround, which will help lower your DSO while increasing cash flow.
• Better screening of customers: It’s not always possible to determine which customers will pay quickly, but screening your customers more thoroughly may reduce the number of delinquent ones.
How do you use days sales outstanding (DSO)?
The best way to use days sales outstanding is to consistently track the results. For example, tracking DSO monthly will allow you to spot seasonal trends, view an increase or decrease in days outstanding, and proactively address any potential issues that may be spotted.
DSO can also be used to analyze the effectiveness of your accounts receivable process, starting with whom you extend credit to and ending with the collection processes used by your business.
Is DSO a good ratio to calculate for your business?
If you sell to customers on credit, knowing your days sales outstanding is important since the collection rate directly impacts cash flow and overall company profitability. Knowing your DSO can also help you take proactive measures to prevent or correct potential issues.
Finally, tracking your DSO over time allows you to view trends, be on the alert if the DSO rises, and make any adjustments to your accounts receivable process.
The post How to Calculate Days Sales Outstanding and Why It Matters appeared first on The blueprint and is written by Mary Girsch-Bock
Original source: The blueprint