As a passionate business owner, you value consistency in both life and business. You take all the necessary steps to stay updated with your firm’s financial situation, while your business undergoes steady growth. You only have one problem: with the increase in your customer base, your accounts receivable process is falling behind and you find yourself having to constantly follow up with customers and send out reminders for payments. There are good days when you send reminders to all of your customers with pending payments, and on other days you have trouble keeping up. Finally, you decide to find out how efficient your accounts receivable process is. The first thing you’re going to want to look at is a metric called Days Sales Outstanding.
What is Days Sales Outstanding?
Days Sales Outstanding (DSO) is the average number of days taken by a firm to collect payment from their customers after the completion of a sale. As a business owner, you can also view DSO as the number of days it takes for credit sales to be converted to cash, or the number of days that receivables remain outstanding until they’re collected.
While DSO is generally calculated on a monthly basis, there are businesses that carry out DSO calculation on a quarterly/yearly basis as well.
This takes us to the next question…
How to calculate Days Sales Outstanding with the DSO formula
DSO calculation can be done using this simple formula:
Days Sales Outstanding = (Accounts Receivable/Net Credit Sales)x Number of days
Example: John, a small business owner, sells his goods and collects payments from his customers within 30 days of each sale. While most customers pay on time, others tend to delay their payments. John wants to get a picture of how efficient his accounts receivable process is. His annual financial statements look like this:
- Accounts Receivable: $30,000
- Net Credit Sales: $350,000
DSO = (30,000/350,000) x 365 = 31.28 approximately
Given that John was targeting a 30-day collection period, his DSO of 31 days is good for his business. John can remain confident that his accounts receivable process is in good shape.
This formula for calculating DSO is limited to credit sales, and cash sales transactions are usually kept out of it. All you have to do is divide your final accounts receivable by the total credit sales for the period (monthly/quarterly/annually) and multiply it by the number of days in the time period.
How does DSO impact your business?
DSO is a useful metric with which you can evaluate many critical business factors, like how quickly your customers are paying you, your firm’s liquidity, the sales made by your firm in a time period, the efficiency of your sales team, customer satisfaction, and customer retention.
The DSO value depends on the size of your business, and there’s no one-size-fits-all here. For example, a DSO of 45 days may not be a problem for a large-scale business, but it is terrible for a small-scale business.
By calculating these DSO trends regularly, you can use them to tweak and make improvements in your business practices. To get the most out of this metric, it’s recommended to measure DSO periodically, rather than making changes based on individual DSO results.
What’s the difference between a high and low DSO?
A lower DSO value indicates that it’s taken fewer days to collect payments for the sales you’ve made. If your DSO is too low, it indicates that your firm is too rigid with payment terms and policies, like penalizing your customer for delaying the payment by only one day. Policies like these would not give much time for customers to get their money together and pay you. However, you can avoid this and make your DSO better by offering discounts to customers who pay early.
On the other hand, a higher DSO value indicates that your firm is allowing a longer duration to receive payments, and worse, your firm is making a lot of sales on credit.
A consistently increasing DSO indicates that your business is headed in the wrong direction with respect to your receivables. A higher DSO is a sign that your customers are taking longer to pay, which in turn means you have to wait for the much-needed funds to be invested in business operations. It could also mean that your sales team may not be following up and communicating effectively with customers or sending them payment reminders.
If this continues, you could end up sending late payments to your vendors. In the worst case, you would have to face negative cash flow, meaning you may end up taking loans to manage your business finances.
Ways to reduce DSO
Invest in online invoicing software
Your payment collection process should be organized and systematic. Investing in online invoicing software would help you do that. You can invoice your customers on time as soon as a sale is made. Delaying the process of sending invoices to your customers will only delay the payments further.
With an invoicing software, you can track payment status, set automated payment reminders to be sent out, and customize your invoices according to individual customers. The additional advantage here is that the invoices have the payment terms (Net 30 or Net 60) and the payment policies of your firm stated on them.
Offer incentives for early payments and penalties for late payments
Offering incentives for early payments is known to accelerate the payment process, as discounts and early-bird offers are well-received by customers. You can also penalize your customers if they are consistently late with payments. Make sure that your invoices contain the late fee terms and conditions, so that the customers know about them up front.
Offer your customers more payment options
Offering your customers a variety of payment options, like card payments and bank transfers will get you paid quicker, since your customers can opt for the most convenient payment option. Also, providing online payment options will often get you paid quicker compared to conventional modes of payment.
Store your customers’ credit card details
If you’re offering recurring services, then auto-charging is your best option. Storing your customers’ credit card details is an easy way to get paid, since you can charge them right on the due date. All you have to do is inform your customers regarding this policy once you set up the system. You’ll also have to notify your customers before and after you charge them.
Let go of bad customers
While customer retention is important, if a customer is constantly paying you late despite repeated reminders and penalties, you may have to re-evaluate your business ties with them. Say, if your average DSO is 38 days and your customer pays after 55 days, it’s time to let them go. If the cost and effort in retaining a customer is beyond the average limit, continuing business with them might not be worth it in the long run.
To sum everything up, if you’ve made a sale, but you haven’t collected the payment on time, it’s counted as a loss for your business. With DSO, you can measure the efficiency of your collection process and come up with practices to get paid quicker. Getting paid quicker means more funds to reinvest for your business operations. With the right tools at hand, you can master your accounts receivable process and stay on top of your cash flow.
