When it comes to managing a company’s finances, it’s critical to understand and monitor accounts receivable metrics. Accounts Receivable Turnover Ratio and Days Sales Outstanding are two significant key performance metrics that aid in collection optimization.
It’s critical for collection professionals to understand and calculate the accounts receivable turnover ratio and days sales outstanding. This assesses the efficiency of a business’s collection operations, which impacts operational cash and short-term profitability.
Understanding Days Sales Outstanding
Days Sales Outstanding is a financial indicator that calculates the average number of days it takes a company to collect payment from a customer(s) following a sale. It is an important measure of an organization’s accounts receivable efficiency and liquidity.
The formula to calculate DSO is:
| DSO = ( Accounts Receivable / Net Credit Sales ) × Number of Days |
Here’s an example:
At the beginning of October, ABC Inc. had $100,000 in accounts receivable and made $500,000 in net credit sales. Therefore, DSO = (100000 / 500000) X 31 = 6.2
This means the DSO for ABC Inc. for the month of October is 6.2 days.
Monitoring Days Sales Outstanding is important for managing working capital and assessing the effectiveness of a company’s credit and collection policies. A lower DSO score is typically preferred since it implies that a company is effectively collecting payments. A higher DSO may suggest that a company is taking longer to collect payments, which could impact its cash flow and liquidity.
Challenges of Assessing the Metric Alone
- Affected not just by payment terms, but also by collection quality
- Can fluctuate substantially even when the company is thriving
- Not affected by seasonal downturns or unforeseen sales surges
Understanding Accounts Receivable Turnover Ratio
The Accounts Receivable Turnover ratio is a financial indicator that determines how well a company handles its receivables. It reveals how frequently a company’s accounts receivable are recovered and replaced during a given time period, generally a year. The following formula is used to calculate the Accounts Receivable Turnover ratio:
| Accounts Receivable Turnover = Net Credit Sales / Average Accounts Receivable Where, Average Accounts Receivable = (Beginning Accounts Receivable + Ending Accounts Receivable) / 2 |
Here’s an example:
Suppose Company XYZ wants to calculate its Accounts Receivable Turnover ratio for the year 2022. The net credit sales are $1,000,000, with beginning Accounts Receivable at $50,000 and ending Accounts Receivable is $70,000. First, Average Accounts Receivable = (50,000 + 70,000)/2 = 60,000. Therefore, the Accounts Receivable Turnover ratio = 1,000,000 / 60,000 ≈ 16.67
This means the Accounts Receivable Turnover ratio for Company XYZ for the year 2022 is approximately 16.67.
The Accounts Receivable Turnover Ratio provides insights into how quickly a company collects payments from its customers. A higher ratio indicates that a company is efficiently managing its receivables, while a lower ratio may suggest that the collection process is slow.
It’s important to note that the interpretation of this ratio may vary by industry, and it’s often useful to compare a company’s ratio to industry benchmarks or its own historical performance. Additionally, a high turnover ratio doesn’t necessarily mean better performance if it is accompanied by excessively strict credit policies that could impact sales.
Challenges of Assessing the Metric Alone
- May suggest that credit lending policies are either too lenient or overly restrictive, but the reason remains unclear.
- Lacks clarification on the underlying reasons driving the numerical outcomes.
Days Sales Outstanding vs Accounts Receivable Turnover Ratio: Key Differences
Days Sales Outstanding and Accounts Receivable Turnover Ratio are both financial metrics that provide insights into a company’s management of its accounts receivable, but they focus on different aspects and are calculated differently. Here are the key differences between DSO and Accounts Receivable Turnover Ratio:
Why Both the DSO and ART Ratio are Crucial for Businesses?
Monitoring both Days Sales Outstanding and Accounts Receivable Turnover Ratio is important for managing accounts receivable operations efficiently. Here’s how these metrics can help you monitor and enhance your AR operations:
Collections Efficiency
DSO measures how quickly customers pay, providing a time-focused perspective on collections efficiency. ART Ratio indicates the frequency of receivables turnover during a specific period, offering insights into overall collections efficiency. Together, Days Sales Outstanding and Accounts Receivable Turnover Ratio provide a comprehensive view of collections efficiency, helping identify areas for improvement and ensuring timely payments.
Cash Flow Forecasting
Low DSO values suggest a healthier cash flow, indicating faster collections. Forecasting accounts receivable using DSO helps gain insights into the business’s financial health. This information aids in making informed decisions about investments, effective resource allocation, and potential reinvestment for sales growth.
Customer Satisfaction
Days Sales Outstanding and Accounts Receivable Turnover Ratio provides insights into customer payment behavior. Clients paying before the due date is indicated by lower DSO and higher ART ratio, suggesting customer satisfaction. This information can be leveraged to enhance customer relationships by offering discounts and incentives, reinforcing customer loyalty.
Streamlining Credit Policies
A higher DSO or a lower ART may indicate lenient credit policies and potential issues with credit limits. Tracking Days Sales Outstanding and Accounts Receivable Turnover Ratio helps you know when to adjust credit policies, ensuring they are aligned with the company’s financial objectives and minimizing the risk of bad debts.
Cross-Examination for Accuracy
Analyzing Days Sales Outstanding and Accounts Receivable Turnover Ratio collectively helps avoid misinterpretations that can arise when metrics are considered in isolation. Seasonal variations or spikes in sales may impact DSO values. Having Accounts Receivable Turnover Ratio to cross-examine insights helps remove errors in judgment, providing a more accurate assessment.
Closing Thoughts
Days Sales Outstanding and Accounts Receivable Turnover Ratio are critical measures for determining the performance of a company’s collections. While every data point provides useful information on its own, combining them provides a holistic view of cash flow and collection operations.
Peakflo’s AI-powered Accounts Receivable Reports improve the accuracy and effectiveness of finance operations by providing visibility into cash flow analytics and key AR indicators.
