Although DSO is widely used by upper management and Wall Street analysts, there are other options out there if DSO is being used to evaluate the effectiveness of departments such as billing, collections and sales.
A look at the standard DSO formula shown below highlights the dilemma. DSO is calculated by dividing total credit sales for a given period (i.e., point in time), such as a month or year, by ending total receivables and multiplying the resulting number by the number of days in the period, 30 days for a month or 365 days for a year.
(Ending Total Receivables / Total Credit Sales) x Number of Days in Period
At year’s end, the net accounts receivables total on a company’s balance sheet is generally a smaller number than total credit sales. If credit sales decline, but receivables increase or are flat, DSO appears to have deteriorated. Or, if credit sales are growing, but receivables are stable, DSO appears to have improved. But, the question is why?
The sales department can be the culprit. A salesperson may offer longer terms to secure a sale. The longer terms will increase DSO. Also, sales and promotions influence DSO. These are timing issues but they can cause a big swing in DSO.
The Collection Effectiveness Index
How do you evaluate the performance of the credit or collections groups? Try the collective effectiveness index (CEI) which was created to demonstrate the effectiveness of collection efforts over time. The closer the resulting percentage is to 100, the more effective are the collection efforts. In the formula below, N represents the number of days or months to calculate CEI:
[(Beginning Receivables + (Credit Sales/N)) – Ending Total Receivables)/ (Beginning Receivables + (Credit Sales/N)) – Ending Current Receivables] X 100
Weighted Average Terms versus Weighted Average Days to Pay
Another good measure is weighted average terms (WAT) versus weighted average days to pay (WADTP) metrics. Unlike DSO, it is not influenced by the level of sales or mix of terms offered, and reflects an average over time. It’s not a point in time. With DSO you are taking a measure of AR and sales on that one day at the very end of the month or at the very end of a quarter. WAT vs. WADTP is an average and is on actual invoices. It’s not in any way influenced by sales. It also helps the credit manager keep track of whether or not payment terms are increasing, which is going to have an increasing effect on DSO.
To compare weighted average terms with weighted average days to pay, use the following calculations:
Weighted Average Terms (WAT) = (Due Date – Invoice Date) X Invoice Amount/Total Invoice Amounts
Weighted Average Days to Pay (WADTP) = (Payment Date – Invoice Date) X Invoice Amount/Total Invoice Amounts
WAT – WADTP = X
No matter which metrics you use in your analysis, look at measurements on more than one level. Sales, billing, collection and credit all influence DSO so each should be measured for their effectiveness in converting accounts receivable to cash. Once you can measure the performance of each department, then you can pinpoint areas for improvement.