Using DSO to Measure and Manage Collection Efficiency

Originally published: Feb-23-2005

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Credit executives have an abundance of measures available to help them quantify and analyze the success of their efforts. One of the most widely used (and some credit executives might say, misused) measures is Days Sales Outstanding, or DSO.

Days Sales Outstanding expresses the average time, in days, it takes your company to convert its accounts receivables into cash. There are several ways to calculate DSO. When used appropriately and consistently, these calculations can help you answer a variety of questions about the effectiveness of your credit and collection policies and practices. For instance, are your credit terms in line with competitors? Are your collection procedures successful in meeting stated goals? Is your customer base risky?

Before discussing the various DSO formulas, a few words about making DSO, or any performance measure meaningful. There are basically six requirements (as outlined in "Performance Measures for Credit, Collections and Accounts Receivable"):

1. The measure should express a value that complements and supports the objectives of your company and department.
2. It must be communicated to all individuals responsible for the process being measured.
3. It must be compared to some standard, for instance, past company performance, or an industry benchmark.
4. It must be used consistently, from month to month, year to year.
5. The results should elicit some action - correcting course, managing change for improvement.
6. It should provide a benefit. This could be as basic as the satisfaction of reaching a goal that contributes to the organization’s success.

Formulas for Calculating DSO

DSO is important as a financial indicator to the extent that it shows the age, in terms of days, of an organization's accounts receivable and the average time it takes to turn those receivables into cash.

It can give insight into the changes occurring within an organization's receivable balance; indicating whether a change occurred because of a positive or negative fluctuation in sales during that period, or if other business factors such as promotional discounts, seasonality, selling terms, etc. created the effect.

Each method for calculating DSO (outlined below) has its own strengths, and each is based on what might be called the Standard DSO formula. The key to making effective use of any of these tools is consistency. Select the methods that work best for you and stick with them.

For each of the example DSO calculations that follow will use the same receivables data, listed below. The date for on which the DSO is calculated will be September 30, 2004.

Sales Periods (for consistency):

• Annual = 365 days
• Six Months = 182 days
• Quarter = 91 days
• Month = actual # days in the month

Note that since the data utilized is limited and quite simple, the various DSO calculations should be close to equal.

Standard DSO Calculation

The Standard DSO calculation provides an average (aggregate) time in days it takes to convert accounts receivables into cash. It should be tracked over time and compared to previous company results or industry/competitor benchmarks.

Standard DSO Formula and calculation utilizing data above:

(Ending Total Receivables / Total Credit Sales) x Number of Days in Period

For the 3^rd Q: ($8,000 / $16,000) x 91 = 45.5 days DSO

Best Possible DSO Calculation

Best Possible DSO utilizes only your current (non delinquent) receivables to calculate the best length of time you can achieve in turning over receivables. It should be compared to the standard calculation above, and be close to your terms of sale. The closer your standard DSO is to your best possible DSO, the closer your receivables are to your optimal level.

Best DSO Formula and calculation utilizing data above:

(Current Receivables / Total Credit Sales) x Number of Days

($3,000 / $16,000) x 91 = 17 days Best Possible DSO

Delinquent DSO (Average Days Delinquent) Calculation

Delinquent DSO or Average Days Delinquent (ADD) calculates the average time from the invoice due date to the paid date, that is, the average days invoices are past due. It provides a snapshot to evaluate individuals, subgroups or overall collection performance.

Delinquent DSO Formula

Standard DSO - Best Possible DSO = Average Days Delinquent

45.5 - 17 = 28.5 average days delinquent

Sales Weighted DSO Calculation

Sales Weighted DSO, as with the regular DSO calculation, measures the average time that receivables are outstanding. However, it is considered by some an improvement over other methods of calculating DSO because it attempts to smooth out the bias of credit sales and terms of sale. (See Gallinger in Resources for Further Information below).

Sales Weighted DSO Formula

{($ in Current Age Bucket / Credit Sales of Current Period) +

($ in 1-30 Day Age Bucket / Credit Sales one month prior) +

($ in 31-60 Day Age Bucket / Credit Sales two months prior) +

(etc.)} x 30

{($3,000 / $5,000) + ($3000 / $6,000) + ($2,000 / $5,000)} x 30
= (.6 + .5 + .4) x 30
= 45 days Sales Weighted DSO

Countback DSO Calculation

Another method for calculating DSO that takes into account sales fluctuations is a formula called the Countback Method. According to an article in the June 2004 issue of Credit Today newsletter, this method provides a more accurate picture of DSO and its month-to-month fluctuations in sales and past due receivables. It also gives more weight to the current month’s sales, making the correct assumption that most of the A/R balance will be from current, as opposed to previous sales. And, it takes into account the real effect of the actual difference in the number of days per month (i.e. 28 in February vs. 30 in April, June, September, November vs. 31 the rest of the months).

The Countback Method can be used with any time frame. If terms are net 30, then monthly balances are used. If terms are net 10, weekly numbers might be used. This method involves three steps.

Countback DSO Formula

Step 1. Days counted back = # of days in current month. September = 30

Step 2. Calculate DSO for periods prior to step 1

Month end net A/R balance - Current month’s sales
= Prior Periods Receivables

Ex. $8,000 - $5,000 = $3,000 prior period's receivables

Note, if the prior period’s receivables is larger than the prior month’s sales, repeat step 1. The DSO will be greater than 2 months.

Prior Period = (Prior Periods Receivables / Credit Sales for Prior Period)
x Number Days in Period (August has 31 days)

Ex. ($3,000 / $6,000) x 31 = 15.5

Step 3. Add DSO for previous period to days counted back in Step 1

Ex. 15.5 + 30 = 45.5 Countback DSO

True DSO Calculation

True DSO calculates the actual number of days credit sales are unpaid by tracking individual invoices to the month of sale.

True DSO Formula

(invoice amount / net credit sales for the month in which the sale occurred)
x number of days from invoice date to reporting date (9/30/04)

September Invoice = ($3,000 / $5,000) x 2 = 1.2 days
August Invoice = ($3,000 / $6,000) x 33 = 16.5 days
July Invoice = ($2,000 / $5,000) x 64 = 25.6 days

Sum of True DSO for all open invoices = True DSO per total accounts receivable

1.2 + 16.5 + 25.6 = 43.3 True DSO

Benchmarking DSO

In general, if your company's DSO is no more than 10-15 days longer than terms of sale, the receivables are turning into cash without much difficulty.

Benchmarking data for DSO is somewhat hard to come by, and even more difficult to find without paying a fee. The Credit Research Foundation (CRF) does a quarterly study, the National Summary of Domestic Trade Receivables (a.k.a., the DSO Survey), that is an examination of the condition of A/R for U.S. companies. The CRF has been collecting this data quarterly since 1960. The results of the complete study are available to CRF members and those participating in the survey.

A view of the Summary data for fourth quarter 2004 is available on the Credit-to-Cash-Advisor.com web site.

Outlined below is some very general DSO benchmarking information. You can get more specific and exhaustive benchmarking information by subscribing on the web site of Strategic Advantage.

Resources for Further Information

Olsen, Rob "Performance Measures for Credit, Collections and Accounts Receivable." Credit Research Foundation web site.

"Why You Should Switch to the Countback Method to Calculate DSO." Credit Today newsletter: June 2004, pg. 1

Gallinger, George W. "An Evaluation of Techniques for Monitoring Accounts Receivable." Columbia: NACM, 1995.

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This information is provided by ABC-Amega Inc. -- providing 1st and 3rd party commercial collection services since 1929, and collecting in more than 200 countries worldwide. For further information, contact info@abc-amega.com.