Understanding Days Sales Outstanding (DSO) and the Role of AR Management in Reducing DSO
Out of numerous business processes and operations, a crucial one on which the survival of the business depends is cash. This is one reason “cash is king”, and the other is that the cash flow in your organization determines your organization’s financial health. But the question persists, how much cash is essential for a business? While there is no definite answer to this, it’s certain that when a company’s cash inflow outweighs cash outflow, it can fund its operations and plan its investments.
Even then tracking cash flow is challenging, especially for large corporations who have numerous business operations and a larger customer base. This is why many business owners and CFOs determine days sales outstanding (DSO) metric which decides how quickly they will get their invoices paid.
Small and medium businesses (SMBs) that neglect the DSO metric can be severely impacted, as they lack visibility into their cash flow, which strains their financial resources and hinders their financial health. So, how can you track and reduce the DSO to unlock your cash flow? This blog will provide an in-depth understanding of DSO and explain how to calculate it. It will also highlight the optimal DSO for businesses and discuss strategies for managing DSO across companies of all sizes.
This is an accounting ratio that is used to evaluate the average number of days it takes a business to receive customer payment. DSO can be measured monthly, quarterly, or yearly. However, businesses with a higher volume of credit sales may not go for yearly calculations. Many businesses calculate DSO monthly or quarterly so they can plan to improve their payment collection rate. While there are many ways to improve DSO, here we will discuss some accounting terms and processes that are directly associated with DSO.
Accounts receivable is closely associated with the DSO which determines collection of payments for goods or services sold on credit. Businesses with a good AR balance have lower DSO which indicates they are collecting faster.
Cash flow is the movement of cash in and out of a business. This is the most significant indicator of a business’s financial health. If you have a healthier cash flow, it indicates efficient payment collection.
The cash conversion cycle (CCC) is another metric that measures the time it takes for inventory to turn into cash. The shorter the CCC the faster your collection rate.
Credit sales is a sales strategy where goods and services are sold on credit, bound by specific payment terms. Before selling on credit, companies evaluate customers’ credit scores to ensure that they are more likely to pay on time.
All the aforementioned terms and concepts play a crucial role in the company’s DSO. These concepts will later be used in proposing strategies to reduce DSO.
Calculating Days Sales Outstanding
To calculate the DSO, you need to determine the total accounts receivable collections of the company in a certain period, the total number of credit sales, and the number of days in which you want to calculate the DSO.
If you are calculating the DSO for the month of January, then your total number of days will be 31 and the formula will look like this;
DSO = (Average AR Collections/Total Credit Sales) x 31 (time period in days)
After calculating your DSO, you will have a number that represents your DSO value. You still need to determine whether this value is high or low. The average DSO for most businesses is around 39 days, but it varies between industries. If your DSO is greater than your industry average, you must manage it for faster collections. Conversely, a lower DSO indicates that you are efficiently managing your collections.
Best Practices to Reduce DSO and Unlocking Cash Flow
There are many best practices to improve the company’s payment collections and reduce the DSO value. But here are the top 5 practices that
1. Improving Accuracy and Timeliness of Invoices
The timely delivery of your business invoices is the first reason that makes your collections efficient. When you can create your invoices with accuracy, this saves your time by recreating your invoices and also prevents invoice delays from your end. Invoice issues are common with businesses relying on manual invoicing processes. Those employing accounts receivable automation solutions will never have to worry about these issues as the solution streamlines all the invoice-to-cash workflows. Even when you implement an automation solution, training your finance teams is crucial to minimize invoicing errors and any other errors that can hamper payment collections.
2. Implement Credit Management Policies
Credit management policies help businesses extend credit to customers after evaluating their creditworthiness, thereby avoiding potential payment delays and bad debt. It is crucial to evaluate your customers’ credit scores; otherwise, you risk increasing your DSO, which translates to delays in payment collections. Crafting credit policies and payment terms is important, but you also need to ensure proper communication so that customers are well aware of these policies, which may include early payment discounts or late payment penalties. If a customer has a good credit score, you can negotiate payment terms and design flexible policies to improve your business relationships.
3. Offer Digital Payment Convenience
Relying on cheques and cash to receive payments causes friction for customers and may extend the time it takes to collect payments. Facilitating electronic payments increases your collection rate due to faster payment processing and quicker invoice settlements. This saves customers the time required to mail paper-based cheques or cash. Many small and medium businesses integrate solutions that allow them to accept ACH payments and credit card transfers, accelerating payment collections and reducing DSO. Using electronic payment methods also protects your finances from invoice fraud, safeguarding your business reputation.
4. Provide Early Payment Discount
While businesses often penalize customers for payment delays, offering incentives for early payment is a more proactive approach. This not only helps you get paid faster but also improves your business relationships, rather than frustrating customers who are already struggling with their cash flow. Though the discount rate is between 2% and 5%, it is enough for the customers struggling with their cash flow.
However, the downside of an early payment discount is that it will eat your profit margins if offered to all your customers. Therefore, you should customize offerings for customers who are delaying their payments. This will help you get paid faster without losing your profit margins.
5. Implement Automation Solution for Payment Reminders
There are many solutions available for invoice follow-ups and scheduling payment reminders to prompt payments. By employing these solutions, you can send automated messages to remind your customers to make payments. This saves operational costs and expedites payment collections, reducing your DSO without necessitating your finance teams to manually reach out to customers by calls and emails. These software solutions also allow you to plan your dunning strategies for customers with overdue invoices. Without frustrating your customers, you can customize the frequency of reminders and adjust the tone to ensure they are not offended by frequent reminders.
The Bottom Line
DSO is a crucial metric that determines your company’s accounts receivable (AR) collection efficiency. If you take longer to collect payments, your cash flow bottlenecks, ultimately impact your company’s financial health. In today’s digital business landscape, employing technological solutions to improve collection efficiency is essential to stay competitive, as these solutions help reduce DSO without needing extra staff. Other strategies to reduce DSO include reducing friction with electronic payments, offering early payment discounts, developing effective credit policies, and streamlining payment reminders to prompt customers to make timely payments.
