It is very important to have a positive cash flow to run a business. Covering daily expenses, paying staff, and repaying loans. When money flows in slower than it goes out, it can be very difficult to grow a company. Or worse, it can put an organization in financial trouble, resulting in a lot of stress. A good solution for this is managing the DSO (Days Sales Outstanding). In this article, we will discuss what DSO is, how to calculate it, why it is an important KPI, and how to improve it.
What is DSO?
In the world of credit management, DSO is the most commonly used measurement tool. The meaning of DSO is Days Sales Outstanding or Daily Sales Outstanding and is a financial ratio that tells you how well debtors pay. DSO is also known as the turnover rate of debtors or debtor days.
What does DSO stand for?
The DSO calculation shows how long it takes for a company to receive payment for an invoice after a service or product has been delivered to the customer. This is often calculated monthly to analyze valuable data over a certain period. An effective way is to track this on a trend line, month after month. This way, it becomes clear what changes occur in your organization’s ability to collect outstanding invoices from customers. You can then effectively anticipate this.
What is meant by the turnover rate of debtors?
DSO is also referred to as the turnover rate of debtors. This ratio indicates how quickly a debtor proceeds to payment. The higher the ratio, the faster this debtor pays, and the more ample the liquidity of the company is.
How do you calculate the average payment term?
There are different ways to calculate debtor days. You can calculate the DSO over a certain period. Many companies do this monthly or annually. But different calculations yield different results. For example, when you calculate DSO monthly, the DSO figure can give a distorted picture. In a month where you sell a lot, the DSO will be lower. And a month where you sell less often distorts the DSO figure positively. An exceptionally high invoice with a longer payment term can also lead to a distorted DSO. We provide you with some formulas to calculate your debtor days.
The DSO formulas
There are several formulas to calculate the debtor days ratio.
The DSO formula over a month:
(Outstanding invoice amount or debtors at the end of the month / monthly turnover) * 30 days
The DSO formula over a year:
(Outstanding invoice amount or debtors at the end of the year / annual turnover) * 365 days
Days Sales Outstanding example calculation
We provide an example. At the end of June, the total amount of your outstanding invoices is €80,000. At the end of July, it is €60,000.
To calculate the total value of your sales, you can take the sales revenue over a certain period. When there are many fluctuations in this, your DSO will also fluctuate. So, suppose your turnover in June is €88,000 and only €40,000 in July, then your DSO is:
In June: €80,000 / €88,000 * 30 days = 27.3 days
In July: €60,000 / €40,000 * 31 days = 46.5 days
For a company with these turnover fluctuations, it is wiser to use the average monthly turnover over 12 months. The debtor days ratio formula is:
Outstanding invoice amount or debtor balance / (annual turnover / 12) * period in days
What is a good DSO?
Generally, a DSO below 45 is considered low, and a DSO above 45 days is considered high. But this very much depends on the type of company and the business structure. Different industries have different average DSOs. A low DSO in one industry can therefore be a high one in another. Is the average payment term of your creditors lower than your DSO? Then you may encounter cash flow problems. It is therefore important to calculate and monitor the DSO.
What is the importance of a good DSO?
A low DSO is good for any company, and a high DSO is undesirable. A high DSO means that a company sells its products or services on credit, which can lead to cash flow problems. Many unpaid invoices, however, face increasing risks; the longer the wait for payment, the greater the risk of default. Additionally, a low DSO has important advantages for any company. Companies with a low DSO have the highest cash flow and face no credit risk. This makes you more attractive to lenders, business partners, and potential investors because the risk is lower.
How can you best monitor DSO?
As previously discussed, calculating and monitoring the DSO is important for the continuity of your business. There are several ways you can keep track of this well.
Calculating days for overdue invoices in Excel
First, you can calculate the number of elapsed days in Excel. This can be useful when you want to know who is late in paying their invoices. You can then take immediate action to get an invoice paid as quickly as possible. To calculate how many days have passed between the invoice date and today’s date, you can use the TODAY function in Excel. The first step is to put all invoice dates in column A. In column B, you can then type the formula: TODAY()-A1. You can then drag this down for the other dates. These numbers give a clear picture of which debtor has exceeded the legal payment term of 30 days. This way, you know exactly where to take action. However, this is a time-consuming and inefficient activity.
Monitoring DSO in debtor management software
You can save a lot of time and energy by monitoring and improving the DSO in debtor management software. By automatically following up on invoices, offering different payment methods, and maintaining consistent dialogue with debtors, you can significantly reduce the DSO with debtor management software. In the Payt platform, you can see at a glance how your DSO is progressing (see figure 1).
Figure 1. The report of payment behavior and DSO in Payt
How can you improve the DSO?
A low DSO is good for a company. But how do you ensure that the DSO improves? We provide tips to reduce the DSO:
- It is important to invoice customers immediately after delivering a product or service. Follow this up quickly to get paid sooner. The willingness to pay is greatest immediately after the delivery of a product or service.
- Be very accurate and specific on your invoice. This avoids questions about the content of the invoice and reduces the chance that customers will put the invoice on a pile to pick it up later. This also decreases the chance that you will have to send new invoices repeatedly and call customers for payment.
- Make it as easy as possible for your customers to pay invoices. For recurring invoices, it is useful to use direct debit. It is also very effective to add payment methods such as an iDEAL button to your invoices. You will see that you get paid much faster. Not only consumers use these payment methods. Companies are also increasingly using them. The record for the fastest payment at Hanze University of Applied Sciences Groningen is 17 seconds after sending the invoice with an iDEAL button on the invoice.
- Ensure that you stay in contact with your customer in an efficient and effective way. If there are any uncertainties with the customer, make sure the customer can easily contact you. If there is an error on the invoice or the customer cannot pay the amount in one go, you want to be able to respond quickly to resolve this, for example by automatically arranging a payment plan. The easier this is for your customer, the sooner you will be paid.
- Does the customer not pay the invoice within the payment term? Then immediately follow up on the invoice by automatically sending reminders at set times. This keeps the payment top of mind with your customer. Not paying invoices is often not unwillingness, but it is important to stay on top of it.
- Use a credit check. This allows you to investigate how reliable your (future) customers are. By keeping an eye on or checking the creditworthiness of your debtors in advance, you ensure that your DSO remains at the right level.
Criticism of the DSO calculation
Although the DSO calculation is used by many companies, there is also criticism of this ratio as a measure of company performance. The reason for this is that the DSO lumps everything together. This means that the average is taken of large and small amounts, good and bad payers, and long and short payment terms. No link is made with the financial health of the portfolio, and as a result, the DSO can change quickly. In certain cases, this gives a too positive result and in other cases a too negative result. You are not assured that if a customer pays on time today, he or she will do so next time. The DSO therefore says little about the future of payment behavior.
Things to consider
As we mentioned earlier, companies need a positive cash flow to run their business. Many cash flow problems can be avoided with a good strategy. For the survival of your company, it is therefore very important to set up credit management properly. A DSO improvement offers a good solution in this. Get a grip on your debtor management and ensure faster and easier payments.
