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The enigmas of the DSO

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The DSO is the main KPI for accounts receivable management but it is not always easy to understand. What is really the DSO?

The enigmas of the DSO The DSO is certainly the most widely used indicator in credit management in all countries of the world.

It is a major stake because of its key role in evaluating business performance and its effect on the working capital requirement (WCR).

However, it is not easy to grasp. It is the subject of discussions the more passionate and discordant that the speakers are experts in credit management. Interpretation of the results of the Days Sales Outstanding can be a nightmare.
What is the DSO? What are the different methods of calculation? How to improve it?

A not so obvious definition

Many people think that the DSO is the average payment time of customers, probably because it is an easy explanation to give and to understand. This is wrong.

Indeed, it is calculated with open receivables, that is to say invoices not yet paid by customers. How can we deduce an average delay of payment then?
If it depends patially on the payment terms granted to customers, it is simply the number of days of sales* recognized and not yet paid.

*the recognition of revenue is not necessarily linked to the billing but in some cases to the advancement of costs (IFRS rules on projects management).

From an accounting point of view, it is called the receivable rotation period.

Like any current asset, the accounts receivables are transitory accounts.

An item (invoice...) created in one of these accounts is not expected to persist but to be cleared after a reasonable time. Otherwise, a doubt arises regarding the collectability of the debt with as a consequence the need to take a provision.

A DSO drift may therefore lead to a decrease of the company's results in addition to an increase of the working capital requirement.

Several calculation methods which do not facilitate its interpretation

It is possible to identify two main calculation methods: the balance sheet method and the roll back method of exhaustion of the receivables by the sales. There are in addition a multitude of variances on data considered by companies to calculate it.

The same method applied in two different companies give different results just because the first one deduct the provisions for bad debts or provisions made for credits to be issued (trade discounts, year-end bonuses ... etc.) from the receivable, which directly influences the result.

In addition, two calculation methods produce different results because they do not have the same sensitivity to the monthly changes in turnover.

It is therefore risky to compare the DSO of several companies. To do this we would need to analyze in detail the calculation methods for often find that they are different.

How to interpret the results

Many credit managers regularly ask themselves one of these questions:

  • Why the result rose 3 days this month?
  • How to explain a sudden improvement (ie reduction)?
The answer is rarely obvious. Indeed, the DSO is the result of several variables that may have contradictory effects and make complex explanation of the causes of the result.

For example, the balance sheet method calculated over 3 months of turnover is very responsive to sales changes. A big month of turnover just realized improves the indicator but will deteriorate in a few months, when it comes out of the calculation when all the debt it has generated has not yet been cleared.
The explanation of the result goes through the analysis of changes in receivable positions: not due invoices and overdue items, credit notes issued, payments received, provisions...etc. This has to be analysed dynamically with the change of the turnover.
Indeed, the DSO may vary in the opposite direction of the evolution of the receivable if the turnover has varied in the same direction but more.

For example, if the receivable has fallen by 50 000 but the turnover last month decreased by 80 000, the DSO will increase.

To better understand the DSO, it is necessary to decline it into parts, for example by current DSO (corresponding to unmatured invoices) and DSO overdue (resulting from the delay of payment of invoices).

It is possible to split it for each type of data that are present in the accounts receivable.

Example of split with the contractual and overdue parts

déclinaisons du Days Sales Outstanding

This breakdown allows to better understand the results and explain the reasons of the changes of the indicator.
In this example, we see that the indicator is deteriorating because of the rise of late payments except for the last figure when overdue started to decrease.
The other advantage is to clearly identify whether the indicator improves for good or bad reasons. For example, if the receivable related to doubtful accounts are deducted from the receivable amount used for calculation , the result will be better in case of new provision due to bankruptcy of a customer, which is not satisfactory.

How to improve it?

The best ways to sustainably improve the DSO are simpler than its daily interpretation. This is to get better payment terms with its customers and to apply them:

...are key actions to do to improve this key performance indicator.

Conclusion

The DSO is an imperfect indicator of performance. It can be coupled with other indicators (overdue rate, unpaid rate ... etc.) to evaluate the performance of a business in accounts receivable management.

With a volatile nature, it must be interpreted on an average of at least several months and do not get excited or tense because of a sudden change.

However, it is essential that it is calculated and followed whatever is the size of the company because it allows to quickly identify a drift of customers' payment behavior and / or of payment terms granted to them.

It is also the main component of working capital requirement, and therefore deserves all the attention of business leaders and managers.

See our tutorial on the DSO and the online calculation tool.

My DSO Manager
Your Debt Collection Software available for all sizes of companies


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Last comments

Your long lengthy explanation of DSO is the exact reason we do not use it for measurement purposes.

DSO in my opinion is not actionable. We use DBT, Days Beyond Terms.

This measurement sets aside varying customer terms codes you may be using with different customer segments within your portfolio.
From :James Sarkkinen
With no disrespect intended, you are providing a very complex solution to a subject matter for which a lender does not necessarily require a rocket science answer.

I agree a distinction should be made for receivables not due and those that are past due .

Generally, current dues far exceed past dues. We look at trends and the potential cash flow derived from forecast turnover. The past helps to form a view on what can be expected going forward.
From :Andrew Chow
So true,,,nice piece!
From :Martyn Shield
I do not calculate DSO as it is not actionable. We us days beyond terms. (DBT) It is a simple calculation which is actionable. It eliminates varying terms codes based on customer segmentation any seasonality with respect to sales volumes. James
From :James Sarkkinen
Change in sales due to seasonality is also a big factor in getting different readings of DSO. Not a good measure of AR performance.
From :Jawad Khan
Thanks for your explanation on DSO. I would rather suggest to watch a simple video on DSO in Investopedia . You may have tried your best to ease a complex topic. At the end I was really confused and it became more complex . Anyway Good job.
Thank you ;-)
From :Harris

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