DSO - an acronym for Days Sales Outstanding - is a valuable indicator in financial management. A company's good health depends on its ability to collect its invoices before it is forced to pay expenses that would put it in difficulty. The DSO is therefore a basis for continuous improvement to optimise cash flow and reduce the risk of payment default.
What is DSO and why is it useful?
DSO measures the time taken between the issue of an invoice and its actual collection. As an indicator, DSO represents the average number of days during which invoiced sales remain uncollected. The lower the DSO, the more positive the signal is for the company's financial health.
More than just a figure, DSO helps companies to :
- Monitor their financial health: a high DSO may signal liquidity problems.
- Optimise cash flow: by reducing DSO, companies can improve their cash flow.
- Make strategic decisions: DSO data can be used to better manage internal credit and collection policies.
It is also a component of working capital requirements (WCR) - the part relating to trade receivables. The shorter the DSO, the lower the WCR. The longer the DSO, the greater the risk of a cash shortfall. Reducing it is therefore a constant objective for finance departments, and one that must be correlated with DPO (Days Payable Outstanding) to determine whether there is an urgent need to do so.
DSO vs. DPO, the best way to manage your cash flow
DPO stands for Days Payable Outstanding and represents the average time taken to pay suppliers. It measures the number of days it takes a company to pay the invoices it receives. In both cases, and apart from any particular difficulties, the two concepts are the subject of potentially regular negotiations.
The relationship between the DPO and the DSO is obvious: it is preferable to have a short collection period and a long supplier payment period, in order to have liquidity and a healthy cash flow. The closer the two numbers are to each other, the greater the risk that a delay will cause at least a temporary problem. And a DPO lower than the DSO is obviously the situation to avoid. If the company has to pay its suppliers before it has been paid by its customers, it will need new liquidity, and therefore credit, to finance itself, which should of course be avoided wherever possible
It is a good idea to regularly recalculate and monitor the gap between DSO and DPO, to take into account the arrival of new customers or suppliers on the one hand, but also to renegotiate certain contracts if necessary or to reduce WCR.
How do you calculate your DSO?
There are two methods for calculating DSO. The first is easy to implement, but focuses on a specific period without taking previous periods into account, while the second takes seasonality into account.
DSO by accounting method
This first method is the simplest and determines the ratio between financial outstandings and sales including VAT. You choose a study period (30 days, 90 days, for example), then use the following formula:
Total amount outstanding (incl. VAT) for the period / Turnover (incl. VAT) for the period x Number of days in the period
While the result obtained is very clear and sets an average number of days for collection of accounts receivable, it is not very effective for any company subject to seasonal sales. Comparison from one month to the next, for example, becomes difficult. As for the DSO per year, it takes too long to effectively guide financial strategy.
However, the DSO calculated in this way makes it possible to distinguish between :
- Current outstandings, for which the DSO results from negotiated payment terms.
- Outstanding receivables, while DSO results from the failure to pay receivables on time. The collection strategy therefore needs to be improved.
DSO by sales exhaustion, or "count back
This approach to calculating DSO involves 'depleting' outstanding receivables using the sales achieved in previous months. The aim is to calculate the number of days' sales needed to absorb all the receivables.
Let's take a concrete example: a company has €60,000 in outstanding customer accounts at the end of November. The turnover achieved over the 30 days of November (€30,000) covers half of this outstanding amount, but there is still €30,000 to finance. We therefore go back to October, where the €20,000 turnover achieved in 31 days reduces the remaining debt to €10,000. Finally, with a turnover of €30,000 in September, you only need a third of that month (i.e. 10 days) to cover the remaining €10,000.
The DSO is therefore 30 + 31 + 10 days = 71 days. The company takes 71 days over the reporting period to recover its receivables, taking into account the variations in sales each month. This more precise method of calculation is, however, more complex to implement.
Improve your DSO using a number of levers
A number of measures can be taken to improve the payment time of invoices issued in general, right from the contractual stage. It is preferable to set ideal payment terms and assess the creditworthiness of customers rigorously from the outset. Renegotiation during the life of a contract can be tricky.
It will be good to:
- Negotiate shorter payment terms, so that you can report late payments more quickly and, if necessary, initiate collection proceedings as quickly as possible.
- Obtain payment of a deposit as soon as the order is placed, thereby limiting the financial risk.
- Implement a proactive collection policy, with regular and potentially automated reminders. Today's technology offers powerful tools for reminding debtors of due dates and preventing risk.
- Identify disputes as early as possible and reduce the time taken to deal with them.
- Use assignment of receivables (insert link to dedicated article as soon as it goes online), the cost of which can be included in the initial price to keep margins intact.
Optimising debt collection is the key to reducing payment delays. Taking the most proactive approach possible will guarantee results. For example, it is possible to take action even before a debt is overdue, by sending reminders warning that a debt is about to fall due. Outsourcing debt collectionis also a growing practice, leaving it to professionals who have all the tools and are trained in good practice to carry out this crucial task.
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