What time is it?? It’s metric time!!
This month we’re talking about Days Sales Outstanding. If you have clients in industries like utilities, telecom, or manufacturing, you no doubt hear this term frequently – but how is it really measured and why is it meaningful?
Who uses it?
Any company that sells a product or provides a service with credit terms – examples include a manufacturer selling its products to a distributor or retailer, a telecom or utility company selling its services to consumers, or a heavy machinery or automotive manufacturer with an in-house captive financing division for its dealer network. One industry that doesn’t typically use DSO is retail – unless a retailer issues their own credit card, they only take payment in the form of cash, checks, or third party credit cards; the product is paid for at the point of sale and a receivable is never created. Days sales outstanding can also be referred to as the average collection period.
How is it measured?
In simple terms, days sales outstanding is the number of days it takes a company to collect its accounts receivable from customers. It is calculated as accounts receivable divided by average daily sales, which is annual revenue divided by 365 days.
What’s in it?
Accounts receivable are accounts balances owed to a company by its customers and are typically reported net of what is called the allowance for doubtful accounts – these are amounts that a company likely won’t actually collect; it’s based on their past experience, customer quality, the economic environment, and the company’s own credit terms & collection policies.
Why is it important?
For many companies, accounts receivable represents a sizable percentage of their net working capital, which is a measure of operating liquidity, or how fast assets can be converted into cash. There is a balancing act between extending payment terms that are appealing to customers and having too much cash trapped in receivables. When done correctly, reducing or optimizing days sales outstanding can free up cash to be invested in growing the business or paying dividends to the company’s shareholders.
What drives it?
One of the primary drivers of days sales outstanding is customer mix – whether a company sells business-to-business (B2B) or business-to-consumer (B2C) can have a significant impact on accounts receivable and DSO. The retail example we illustrated earlier is a great example of customer mix – retailers usually have a DSO of zero days as their customers are consumers paying with cash or a bank credit card. Your wireless service provider sets your credit terms – you may have 30 days to pay your bill from the time you receive it; the same holds true for your electric or gas provider. These are both B2C industries. Telecom and utilities will often have a DSO between 45 and 55 days.
However, on the other side of the coin are B2B industries like pharmaceuticals or software & services – often these industries will carry DSO of 70 days or more; this is partly driven by the fact that conventional credit terms in the B2B environment are longer than in the B2C industries. Other drivers of DSO include the creditworthiness of a company’s customers – those with better credit will pay faster, those with more questionable credit may have trouble paying on time; invoice disputes – the volume and severity of disputes will affect overall DSO as those invoices being challenged won’t be paid until the dispute is resolved; and credit terms – a company may try to increase sales by extending longer, more appealing payment terms to its customers.
What is the Goal?
Typically, the lower the number of days sales outstanding, the better. However, it is important to remember that the optimal number of days sales outstanding is a balancing act between the actual investment in accounts receivable and the impact to revenue. A company could arbitrarily shorten its credit terms as a way to free up cash, but if the faster payment terms demanded of customers affects their willingness to purchase the company’s products or services, revenue may suffer as a result.
So how do you translate this into conversation about value with your clients?
We’ll follow this up on Thursday with The KPI Connection, connecting this month’s metric to key business processes and ultimately measurable impact on your clients’ business, so check back for that.
