What is Days Sales Outstanding (DSO)?
Days Sales Outstanding (DSO) is a metric used to gauge how effective a company is at collecting cash from customers that paid on credit.
DSO measures the number of days it takes on average for a company to retrieve cash payments from customers that paid using credit – and the metric is typically expressed on an annual basis for comparability.
- What does the days sales outstanding (DSO) metric measure?
- What is the days sales outstanding (DSO) formula?
- In terms of the impact on free cash flows, would a higher or lower DSO be preferred?
- Why is it important to benchmark the DSO of a company against its industry peers?
Table of Contents
Days Sales Outstanding (DSO) Definition
The accounts receivable (A/R) line item on the balance sheet represents the amount of cash owed to a company for products/services “earned” (i.e., delivered) under accrual accounting standards but paid for using credit.
More specifically, the customers have more time after receiving the product to actually pay for it.
Since days sales outstanding (DSO) is the number of days it takes to collect due cash payments from customers that paid on credit, a lower DSO is preferred to a higher DSO.
- A low DSO implies the company can convert credit sales into cash relatively fast, and the duration that receivables remain outstanding on the balance sheet before collection is shorter.
- But a high DSO indicates the company is unable to quickly convert credit sales into cash, and the longer that the receivables remain outstanding, the less liquidity the company has.
The reason DSO matters when evaluating a company’s operating efficiency is that faster cash collections from customers directly leads to increased liquidity (more cash), meaning more free cash flows (FCFs) that could be reallocated for different purposes rather than being forced to wait on the cash payment.
Interpreting DSO – Higher or Lower?
As a general rule of thumb, companies strive to minimize DSO since it implies the current payment collection method is efficient.
If DSO is increasing over time, this means that the company is taking longer to collect cash payments from credit sales.
On the other hand, DSO decreasing means the company is becoming more efficient at cash collection and thus has more free cash flows (FCFs).
That said, an increase in A/R represents an outflow of cash, whereas a decrease in A/R is a cash inflow since it means the company has been paid and thus has more liquidity (cash on hand).
- Low DSO ➝ Efficient Cash Collection from Credit Sales (Higher Free Cash Flow)
- High DSO ➝ Inefficient Cash Collection from Credit Sales (Less Free Cash Flow)
Days Sales Outstanding (DSO) Formula
The calculation of days sales outstanding (DSO) involves dividing the accounts receivable balance by the revenue for the period, which is then multiplied by 365 days.
- Days Sales Outstanding (DSO) = (Average Accounts Receivable / Revenue) * 365 Days
Let’s say a company has an A/R balance of $30k and $200k in revenue. If we divide $30k by $200k, we get .15 (or 15%).
We then multiply 15% by 365 days to get approximately 55 for DSO. This means that once a company has made a sale, it takes ~55 days to collect the cash payment.
During this waiting period, the company has yet to be paid in cash despite the revenue being recognized under accrual accounting.
The product/service has been delivered to the customer, so all that remains is for the customer is to hold up their end of the bargain by actually paying the company.
Similar to the calculation of days inventory outstanding (DIO), the average balance of A/R could be used (i.e., the sum of the beginning and ending balance divided by two) to match the timing of the numerator and denominator more accurately.
But the more common approach is to use the ending balance for simplicity, as the difference in methodology rarely has a material impact on the B/S forecast.
DSO by Industry
The exception is for very seasonal companies, where sales are concentrated in a specific quarter, or cyclical companies where annual sales are inconsistent and fluctuate based on the prevailing economic conditions.
It is technically also more accurate to only include sales made on credit in the denominator rather than all sales.
But again, this is rather rare in practice since not all companies disclose the sales made on credit and the timing, which is important because DSO does not provide much insight as a standalone metric.
For example, a DSO of 85 days could be the industry standard in a high-end industrial products manufacturer with commercial customers, expensive pricing, and low-frequency purchases, whereas 85 days would be a concerning figure for a company in the clothing retail industry.
For this clothing retailer, it is probably necessary to change its collection methods, as confirmed by the DSO lagging behind that of competitors.
Methods to Lower Days Sales Outstanding (DSO)
For companies with DSOs higher than that of their industry comparables, some methods to lower the DSO would be to:
- Decline Payments via Credit (or Offer Incentives such as Discounts for Cash Payments)
- Identify Customers with Repeated History of Delayed Payments (Place Targeted Restrictions – e.g., Require Upfront Cash Payments)
- Perform Customers Credit Background Checks – Relevant for Installment Payment Agreements
However, in certain cases, extended DSOs could be a function of a customer making up a significant source of revenue for the company, which enables them to push back their payment dates (i.e., buyer power and negotiating leverage).
Thus, it is important to not only diligence industry peers (and the nature of the product/service sold) but the customer-buyer relationship.
For example, a major customer that has a track record of delayed payments is not considered as problematic, especially if the relationship with the customer is long-term and there have never been any past concerns of this particular customer not paying.
DSO Calculator – Excel Template
A/R is ordinarily forecasted based on days sales outstanding (DSO). To get started with this exercise, download the file using the form below to follow along:
DSO Example Calculation
In our hypothetical scenario, we have a company with revenues of $200mm in 2020. Throughout the projection period, revenue is expected to grow 10.0% each year. The first step to projecting accounts receivable is to calculate the historical DSO. The DSO for 2020 can be calculated by dividing the $30mm in A/R by the $200mm in revenue and then multiplying by 365 days, which comes out to 55. This means that on average, it takes the company roughly ~55 days to collect cash from credit sales.
Here, we only have a single data point to work with (2020 DSO = 55 days), but for modeling on the job, it is ideal to take a close look at historical trends over multiple years.
If the DSO has remained consistent year-over-year, then you could simply extend the DSO assumption to future years (i.e., link to the cell on the left). Or, you can take the average of the past couple of years to normalize for any minor cyclicality.
But if DSO has been trending upward or downward, this would warrant a more in-depth look into what is happening internally at the company.
If a company is making progress towards becoming more efficient at collecting payments, then A/R days should gradually continue to decrease over time.
However, the cause of the decrease in DSO should be identified before blindly carrying the assumption forward.
In addition, as a sanity check, DSO assumptions should also be referenced against the average DSO of comparable peers.
Accounts Receivable Projection Using DSO
Now, we can project A/R for the forecast period. To do so, we will divide the carried-forward DSO assumption (55 days) by 365 days and then multiply it by the revenue for each future period. For example, A/R is forecasted to be $33mm in 2021, which was calculated by dividing 55 days by 365 days and multiplying the result by the $220mm in revenue.
The completed output for the A/R projections from 2021 to 2025 is as follows: