DSO stands for “days sales outstanding” which is a measure of the average number of days a company takes to collect revenue after a sale has been made. A low DSO number means a company has an efficient collections process because it takes the company fewer days to collect its accounts receivable. A high DSO number shows that a company is selling its product to customers on credit and taking longer to collect money.
High DSO numbers can mean a couple of things: 1) collection efforts and credit policies are subpar, 2) the company is helping to finance its customers. For example, if customers can take longer to pay vendors, they can use those funds to finance business growth. While this is a win-win for the customer, the vendor struggles to meet everyday obligations such as payroll and other business payments. Thus, a company that chooses to extend credit to a help grow revenue walks a fine line between growth and operating cash shortfalls.
(Accounts Receivable divided by Total Credit Sales) X Number of Days
Due to the high importance of cash in running a business, it is in a company’s best interest to collect outstanding receivables as quickly as possible. By quickly turning sales into cash, a company has the chance to put the cash to use again – ideally, to reinvest and make more sales. The DSO can be used to determine whether a company is trying to disguise weak sales (e.g., poor credit policies), or is generally being ineffective at bringing money in.
For most businesses, DSO is looked at either quarterly or annually but maybe this number should be looked at more often. DSO trends are objective and can tell management if there are issues in credit or collections so proactive decisions can be made and unfavorable trends reversed.
While there are many ratios management should look at, it is important to have a “dashboard” of important, key items which can help a company stay on track. DSO is just one. Later blog posting will discuss a key ratio that takes into consideration inventory and accounts receivable turnover, the cash conversion cycle. Stay tuned!