What is Days Sales Outstanding?
Days Sales Outstanding (DSO) is a metric used to gauge how effective a company is at collecting cash from customers that paid on credit.
How to Calculate Days Sales Outstanding (Step-by-Step)
Days sales outstanding, or “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.
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.
- Low Days Sales Outstanding ➝ A low value 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.
- High Days Sales Outstanding ➝ But a higher value 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 lead 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.
Days Sales Outstanding Formula (DSO)
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.
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.
- Accounts Receivable (A/R) = $30,000
- Revenue = $200,000
- A/R % of Revenue = 15%
- Days Sales Outstanding (DSO) = 15% × 365 Days = 55x
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.
What is a Good Days Sales Outstanding?
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).
As a general rule of thumb, companies strive to minimize DSO since it implies the current payment collection method is efficient.
Recall that an increase in an operating working capital asset is a reduction in FCFs (and the reverse is true for working capital liabilities).
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)
DSO Interpretation 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.