The Love/Hate Relationship Between DSO and the Collections Professional
Chances are if you’re reading this blog, you’re probably pretty familiar with the term DSO – or days sales outstanding. If you’re a finance or credit/collections professional, you might even know what your company’s DSO is and track it on a monthly basis! DSO’s impact can be felt well beyond the finance department, as it reflects the size of a company’s outstanding accounts receivable (A/R) – one of the largest assets on a balance sheet.
What we’ve learned from speaking to our customers is that credit and collections managers sometimes have a love/hate relationship with DSO. Why is that? In business, an increase in something is generally seen as a positive thing, such as revenue or efficiency. But in terms of DSO, an increase is often negative because it potentially indicates less efficiency and a reduction in free cash flow.
DSO is more nuanced than that, though. Finance professionals know that an increase in DSO doesn’t always reflect the true efficiency of the collections team. So while DSO is an incredibly valuable metric, it also catches a bad rap for this reason.
With that in mind, let’s take a deeper dive into what DSO is, what DSO is not, and how to calculate it.
Defining Days Sales Outstanding
DSO is often confused for “the time it takes to fully collect unpaid invoices.” Mathematically, this has no direct relationship to the number of days it takes to get paid; it’s simply an indicator of how many days of sales are tied up in receivables.
Many elements can affect this metric.
For example, DSO can vary from month to month over the course of a business cycle, especially if an organization is seasonal. DSO even varies wildly by industry, as demonstrated by recent research from The Hackett Group:
What DSO Is Not (Introducing the Love/Hate Relationship)
Now that we have a formal definition of DSO, let’s take a look at its direct business impact. DSO extends past the finance department and into the sales force as it is a direct component of sales. For example, a company’s sales impacts how DSO increases or decreases.
This fact begins to explain why collections professionals may fall in and out of love with the metric, and why DSO may not always be the best measure of a credit and collections team’s true effectiveness and efficiency. Billtrust’s VP of Product Strategy, Art Hernandez, had the following to share on the matter. “If you were to speak with a credit and collections manager about their opinions on DSO, their thoughts most likely would be that it provides only one perspective of the overall picture. More importantly we should look at complementing metrics to provide us a true reflection of how we are performing. While DSO is fine – and by its nature uses sales as a criteria which we have minimal influence on – we should also measure trends such as collector effectiveness, overdue percent, dispute aging and closure rates.”
For example, what if your DSO improved by 20 days? Sounds amazing at first, but this scenario actually indicates that either less of your product was sold, or that customers actually paid everything on time. The latter being completely unrealistic!
How to Calculate DSO
As previously mentioned above, a company’s A/R balance is one of the largest assets managed on a balance sheet. With that said, DSO is a vital metric for indicating how much cash is outstanding.
Here is an easy way to calculate DSO. First, you want to make sure you have the following numbers handy:
- Current A/R balance
- Annual credit sales revenue
Let’s say you run a B2B company that generates about $365 million in credit sales. We can say on average, one day’s sales is about $1 million. If your average A/R balance for a given month is $48 million, that means you have 48 days worth of sales sitting on your book. The number of Days Sales Outstanding = 48.
Your DSO formula will then look like this:
While DSO might not paint the entire picture, for credit and collections teams, it does help to articulate very important parts of it. It also is a critical bridge between sales and the A/R team.
In our next blog post, we’ll discuss another common metric used by A/R teams, the Collector Effectiveness Index (CEI), and why it’s a better metric for measuring the effectiveness of credit and collections professionals.
Want to learn more about DSO and the impact it has on your business? Simply reach out to [email protected].