- The average payment term granted to your customers resulting of the trade negotiation,
- The average number of days of delayed payment (or early payment) based on your performance in cash collection.
The DSO has a direct impact on the Working Capital Requirement (WCR), the cash and the overall risk to have unpaid invoices and bad debts.
Lower is your DSO, the lower is your WCR and your overall risk of unpaid customers. Impacts are a better cash flow and profitability.
If your DSO is high, your WCR increases and consumes financial resources of your company. The overall risk of default customers rises as well resulting in accruals for doubtful accounts, which directly impacts profitability and the net result of your company.
Calculate your DSOThe DSO is not a perfect indicator as it may be fluctuating because of many different reasons. However, it remains the main KPI to assess credit management performance. There are many methods of calculating DSO.
The roll back methodWe propose to use the most coherent and fairer calculation of DSO by depletion of accounts receivable by turnover.
Once the DSO is calculated, it is important to understand the reasons of its level. Has it increased because of longer payment term granted to customers? Or because more overdue invoices? Or due to less down payments received from customers...etc. This work analysis is key in order to take good initiatives to improve it.
The DSO in My DSO Manager
The DSO is a key performance indicator in My DSO Manager calculated in real time by week or by month.
It can be computed at many levels: for all accounts receivable portfolio, by customer groups, by customer, or by analitycal field (activity, profit center, etc.).
The DSO is divided into a contractual part (corresponding to not due invoices) and overdue part (due to late payments). See more with online demo.
The balance sheet methodThis is another classical way to compute the DSO. Its advandage is to be very simple and to be close to other financial ratios done on the balance sheet.
AR: Accounts receivable amount at end of the periodThe period chosen is often 3 months, ie 91 days. It is possible to perform the calculation over a longer period but the indicator is less accurate in this case.
Nb days: Number of days of the period
Sales: Amount of Sales including tax of the period.
Formula: AR / Sales x Nb of days
Disadvantages of this method: the result is very volatile from one month to the next and it is strongly impacted by the variations of turnover, which is not representative of the performance in the management of the receivables. It is unwise to draw conclusions about a sudden drop or rise in this index. It must therefore be interpreted over the medium term taking into account, for example, a sliding average over 6 months.
How to improve your DSO?
Improving DSO represents an achievable Grail for businesses. Indeed, it is the main lever to reduce the Working Capital Requirement, and therefore improve the cash flow and the investment capacity of the company.
Trade receivables usually represent in average about 30% of total balance sheet of companies. Reducing receivables with a lower DSO improves the creditworthiness of the business and releases financial resources which will be much better used elsewhere (investment...etc.).
Main ways of DSO improvement:
- Negotiate shorter payment terms with your clients,
- Get down payments and deposits systematically. Include 20% down payments in your terms and conditions of sales.
- Put in place a process of dispute management in order to resolve commercial / technical disputes very quickly.
- Offer discounts to encourage customers to pay you faster,
- Collect efficiently your invoices to reduce late payments and to be paid at the contractual due dates.
ConclusionThe DSO is a key performance indicator in credit management and it can be calculated in several ways according to the method and the data taken into account (deduction of provision from the AR, adding of unbilled revenue to the sales, ...).
The understanding of the DSO results can be complex in some cases. See our article about the enigmas of the DSO.
Beyond to the cash and WCR stakes covered by the DSO, this indicator also shows the quality of the organization of a company. If it is too high, it may be due to lack of efficiency at one or several steps of the sales process.
Indeed, the "box" of overdue invoices is like a receptacle in which each invoice represents a malfunction in the sales process. Each overdue has an internal cause that can be the starting point to improve internal processes:
- Overdue due to a delivery problem.
- Invoice unpaid because customer creditworthiness. This cause indicates a flaw in the analysis of customer risk and in securing receivables.
- Late payment due to lack of customer reminders. This highlights a poor management of Accounts Receivable and collection.
- Invoice rejected due to error on the invoice (missing PO number, wrong company name, ...)