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High DSO vs Low DSO - How does it affect AR health?

High DSO vs Low DSO - How does it affect AR health?

Having cash stuck with debtors can be a double whammy for businesses. They not only have to face delays in receiving payments but also have to spend significant amounts of time and effort following up with customers for cash collections. Cash is crucial to make strategic decisions pertaining to budget and  forays into new businesses and team expansions. Despite all the efforts that a company might put in to get their outstanding receivables cleared, customers might often default on payments. Sometimes, these receivables are never recovered resulting in significant amounts of money being written off as bad debts.

Needless to say, one of the most difficult tasks for a CFO is managing cash inflows. One of the metrics that has emerged as an industry benchmark for helping the finance organization track the health of AR is the DSO or the Days Sales Outstanding.

What is Day Sales Outstanding (DSO)?

DSO is the average number of days a company takes to collect payments from its debtors. Credit sales are common for any business and it becomes a CFO’s responsibility to convert credit sales to cash to ensure that there is no piling up of outstanding cash.

Here’s how to calculate Day Sales outstanding or DSO

DSO = (Accounts Receivable/Total Credit Sales in the measured period) X Number of days in the measured period

  • Accounts receivable is the total value of receivables during a certain time period. While some businesses calculate it based on tenure, others consider the closing receivable balance.
  • The number of days indicates the days in the period. It could be monthly, quarterly, or yearly.
  • Total credit sales includes business done on credit for customers. The payment in this case is not instant and is agreed to be paid at some point in the future.

So how can tracking your DSO help your business?

Evaluate Critical Business Factors

Day sales in AR shows how effective your business has been in collecting outstanding payments. This can in turn help the business perform financial analysis, which is necessary for stakeholders to understand and foresee the business performance. Investors often use this information to determine whether or not to proceed with the next round of funding.

Enhances working capital

To ensure continuity of the business and to cover unexpected expenses, a business needs a substantial reserve of working capital. Managing working capital involves managing inventory, receivables, and payables.  By indicating the future cash flows, the Day Sales Outstanding can help manage receivables.. Well performing companies should always maintain a low DSO to ensure a healthy cash flow.

To understand customer satisfaction

Besides helping predict cash flows and outstanding payments, DSO indirectly tells you how satisfied your customers are since payment delays can happen from unhappy customers. This angle of understanding solves various problems related to product, service, or customer satisfaction.

5 Ways to improve DSO to maintain good cash flows

Five ways to improve your DSO

1. Know your current DSO

Understanding what your current DSO is and benchmarking it against the industry standard can help you decide if you should work on improving it. If it’s too high, identify the pain points that are blocking collections and start digging in to fix them.Going back and reading your numbers throws light on the exact reason why your payments are stuck with your debtors.

2. Accelerate the collection process

Revisit your debtors’ list and identify those who have a history of delayed payments, owe huge amounts to your company, or are unresponsive to emails and phone calls. Categorizing your debtors under various buckets can help come up with a refined strategy to reach out to them.

3. Use Automation tools to streamline your AR

Identifying the payment behavior of various debtors and categorizing them will help you find an efficient way to collect better. Doing this manually can be very challenging especially in a fast-growing business where the booked revenues keep increasing constantly.

To save time, energy, and cash, always opt for AR automation tools. They help in streamlining collections and deepening your understanding of the health of the AR process. It can also help you predict your cash flow better.

A solution like Growfin can help you create intelligent strategies for better AR collection so that manual grunt work is automated and your team has more time to focus on building customer relationships.

4. Early payment incentives

Customers often need a push to make payments from their end. Sometimes, an incentive can work like a charm. Highlight discounts or incentives for prompt payments and motivate your customers to pay on time.

5. Offer more than one payment option for your customers

Seamless payment process translates to prompt payments. Offer your customers more than one payment option via cards, payment gateways or cash. This is also a way to improve customer experience and satisfaction.

High DSO vs Low DSO — How does it impact the business?

A higher DSO shows that the company takes a long time in collecting the cash from its credit sales. On the contrary, a lower DSO depicts that the company has an effective collections process to collect their money before the due date or with lesser delays. The average time that a company takes to collect its cash from its debtors helps determine the company’s cash flow. 

Receivables aging shows the number of outstanding invoices categorizing them by the length of time for which they have been outstanding.  To keep receivables aging under control the AR manager struggles to ensure a lower DSO. Lack of real-time visibility with AR collections stands as a pain point for AR managers to ensure a lower DSO.

DSO calculation is important because it determines the company’s ability to collect cash faster and efficiently. This means they have a collections process that helps them stay on top of their collections thus resulting in lesser or no bad debts. While understanding DSO numbers for a single period helps know the outstanding, these numbers when presented over a period of time help identify the efficiency of the accounts receivable process.

According to Dun & Bradstreet, the 2022 Q1 report shows that 16 out of 219 industries have more than 10% of their aging dollars in 90+ days past due bucket.

So, what does having a high DSO mean? There are two possibilities here. One example is when you have invoices stuck on the far right of your aging buckets. The other scenario is when your invoices are distributed fairly evenly across your aging buckets. Both of these scenarios can have a negative impact on your business. A high DSO can lead to the following challenges:

  1. Unit economics effects for low margin businesses - If your company has low or no profit margins, spending a lot of time, money, and resources on collecting invoices can be a drain on your finances. You will end up making no profit or even spending more money on this activity.
  2. Cash flow issues - Because your cash is stuck with debtors, you may be unable to pay for basic business expenses such as paying employees or procuring raw materials, among other things.
  3. High DSO is a deal breaker - Deals and contracts are frequently terminated due to irregular or delayed payments. This can have a negative impact on your reputation in the long run.
  4. Legal issues - Not having a proper debt collection strategy can drain your resources and money in dealing with the legal issues that come with it. In a world where every second counts, you will spend hours processing legal proceedings that could have been avoided.
  5. Higher bad debts - When you quit trying to collect your debts, you write them off as bad debts. This is a significant loss for the company, and repeating it may even result in the closure of your business.

When you don’t aim to better your collections process your debtors slide by and fall into buckets with higher days of outstanding payments eventually leading to a higher DSO. But DSO is not the only metric that you should be looking at.

DSO Example calculation

DSO calculation can help understand the way the company is collecting and throws light on various aspects of efficiency in the collections process. Let’s take a hypothetical example of calculating DSO. 

Let’s say we have a company that’s making $300mm in revenues. And let’s assume that the outstanding collections from debtors are $40mm. The revenue in this example is expected to grow at 10.0% every year. To project AR we first have to calculate historical DSO. In this example, the DSO is calculated by dividing $40mm in AR by $300mm in revenue and multiplying the resulting number by 365 days. Here the number comes to 49.

This means, our company here takes 49 days on average to collect their outstanding payments from credit sales. When this is done over a period of time, we arrive at the historical DSO. This will help us determine the AR. If the company adopts a more streamlined collections process, then the DSO will gradually come down over time. To bring down DSO, the underlying problem in the collections process has to be identified.

If you are a fast growing business, then DSO may not be the right metric for you

While DSO is a great metric for most businesses to understand the health of the AR process, sometimes, it might not bring out the true status of your AR. In a fast growing start up, the booked revenues grow at a massive rate.

Circling back to the DSO calculation, you would notice that the outstanding receivables is always going to be on the higher side in a hyper growth business. Chances are that the DSO is probably going to be high most of the time due to the new receivables added recently and not because of the earlier outstanding invoices.

In addition to this, during calculation, DSO adheres to a fixed credit period. As a result, it works best for traditional businesses where the credit period is the same for all customers. Such businesses do not anticipate significant sales growth every month, quarter, or year.

DSO is not the right metric to understand cash flow for a fast-growing company or other seasonal businesses that experience 3x or 5x growth over months in a year. So, what is the best metric?

Have you considered ADP? This is an often-overlooked metric. We will tell you why you should weigh this over DSO. But that’s for another day!

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