Let’s start by defining what DSO means. 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. if I send an invoice of January 1st with a payment due date of January 31st and the customer ends up paying on February 14, the DSO for this customer and invoice is going to be 45 days.
Now do this calculation for all your customers and invoices, take an average and you have your average DSO.
Why is DSO an important business metric?
A business can measure its financial health with DSO. How fast a company can collect its receivables back indicates its impact on working capital. DSO is a critical metric because it can help you understand the health of your customers and the quality of your service.
High DSO: A high DSO indicates that a business is taking more days to collect its debt. It is potentially a sign that its product and services have issues and customers are holding their payments until all issues are resolved. Or worse that the customers are not doing well financially and holding their payments until they have enough cash flow to pay their bills. You are basically lending them for free working capital. Both cases are red flags and need to be investigated.
Low DSO: A low DSO means a business is collecting its debt within its payment time and that it has promptly paying customers. This is a sign that the business is healthy; its product and services are valued and customers are satisfied.
Days Sales Outstanding = (Average Accounts Receivable balance)/(Annual Revenue) x 365.
Let’s say a business has an A/R balance of $50k and $500k in revenue. If we divide $50k by $500k, we get .10 (or 10%). We then multiply 10% by 365 days to get approximately 36 days for DSO. This means that once a company has made a sale, it takes ~36 days to collect the cash payment.
DSO is a key metric for your Executive Dashboard
as discussed above, high DSO is a red flag that can cause some long-term cash flow issues. We recommend that you track your DSO on your weekly or monthly business dashboards and ensure that your team reacts quickly when the DSO starts get higher than normal
Additional information on how to reduce your DSO by automating your invoice collection process can be found here.