DSO is the most common form of measurement in every credit management function. The DSO ratio is an indication of how long it takes for an average invoice to be paid after having delivered a service or product. DSO has traditionally been the primary responsibility of the credit management function, however in more recent years, the shift has very much been on a joint effort with involvement with Sales functions. The DSO is a key indicator when measuring performance of a company with its direct impact on cash flow. This wiki explains the importance of DSO and how to improve it. We also highlight some of the criticisms of the ratio.
What is DSO?
It refers to the average number of days that a company receives payment after the issue of an invoice for the sale of products or services delivered.
High or low DSO?
A high DSO is an indication of high exposure to risk and the possible threat of bad debt. It indicates a less effective credit management and a risky customer portfolio. A much lower DSO on the other hand reflects a much more proactive credit management function, staying on top of their invoices to maintain a healthy cash flow for the business.
Amongst various other reasons, a high DSO is often caused by:
- Unwillingness from customers
- A poorly organised accounting and billing process
- Contractual longer payment terms. Larger companies may have longer payment cycles due to their reliance upon the benefits of supplier credit.
What makes DSO so important?
A high DSO is often caused by poor paying customers. Some of which will default and the inherited bad ddebt may have threatening consequences for even the more financially strong companies. Late payment can cause companies a great dealt of financial strain together with lost opportunities for investment as a result.
‘True turnover’ can only be classed when payment has been made after the issue of invoices and delivery of products or services in exchange. Late payment and bad debt eats into turnover which has negative effects on a company’s cash flow. The consequence of which could be in lost opportunities of investing the money to attain interest.
Less external financing and interest costs
Another important reason to pursue prompt payment is to have more working capital in the business. With companies often reliant upon loans from banks that come with an element of interest, securing more cash in the business is essential to avoid huge sums of interest payments. With loans from banks not easy to come by of late, cash is king and should be taken more seriously.
More likely to loan on better terms
An equal reason to focus on DSO is that banks tend to lend quicker and offer greater terms of repayment on loans based on clear evidence of due diligence and better understanding of state of affairs.
If a company can provide transparency and control is in the portfolio, lenders have a better understanding of the state of affairs. This makes the probability of new credit and payments terms substantially greater.
How to reduce your DSO?
Doing business with credit worthy companies
Requesting information through a business credit report, you’ll be able to determine the financial position of company and decide whether they’re the right company to be doing business with.
Majority of SMEs and larger corporates monitor the credit worthiness of new customers with a growing percentage due to the increased levels of bankruptcies. This enables companies to stay clear of the risk with late payment and bad debt.
Timely collection of outstanding payments
A well thought out invoicing process can greatly impact the DSO. It all starts with setting clear payment terms in writing with the client in a timely manner to allow for prompt payment.
Large companies with huge portfolios tend to insure themselves against bankruptcies and bad debt through credit insurance. When financial problems arise with their customers, they’ll be covered with a portion of the outstanding amount owed and will be reimbursed accordingly.
How to calculate DSO?
This is the average time in days to convert accounts receivables into cash.
(Ending Total receivables/Total Credit Sales) x Number of Days in Period
Best possible Method
This method only utilises your current receivables to calculate the best length of time you can achieve in turning over receivables.
(Current receivables/Total Credit Sales) x Number of Days
Use the Graydon DSO calculator to not only calculate your current DSO, but in addition, how much you could possibly injected into your business with a reduction in DSO.
Criticism of the DSO ratio
Despite being a common metric used by most companies, DSO also receives a fair share of criticism. The criticism is particularly directed at the financial status of paying customers. The argument lies with DSO being used an average between good and bad payees and doesn’t factor the financial status of the payee. A good payee today, may be a poor payee tomorrow.