You might have heard of the phrase “cash is king”, particularly when it comes to business. Truth be told, a healthy cash flow separtes entities that thrive from those that burn out completely. Having a healthy cash flow means that your business won’t have problems paying the bills that keep it going.
A vital component of a healthy cash flow is great-performing accounts receivables. Measuring how well your business can collect cash payments is critical to ensuring its survival. That’s where days sales outstanding, or DSO, comes in. DSO measures a company’s efficiency at collecting the cash owed to it.
In this article, we’ll explain the significance of DSO and how you can revamp it to improve your company’s liquidity. After going through this post, you’ll better understand:
- Why carefully tracking your DSO is beneficial for your company.
- Why maintaining optimal days sales outstanding is vital for preserving a healthy flow of cash.
- How you can reduce your company’s day sales outstanding so that nothing holds it back from reaching new heights.
How to Calculate DSO
Companies often assess their DSOs monthly, quarterly, and annually. The Days Sales Outstanding formula is as follows:
To get your company’s DSO for a particular time frame, divide the total value of accounts receivables for a specific period by the total sales within that period. After getting the results, multiply it by the number of days of your chosen period.
Following this simple formula, you can determine how many days on average your company takes to collect payments from customers.
For example, say Company ABC made a total revenue of $120,000 last month, $80,000 of which were on credit. At the end of the month, the company had $80,000 in accounts receivables. Using the Days sales outstanding formula, we can determine the DSO number in days.
($80,000 / $120,000) * 30 is equal to a DSO of 20 days.
Company ABC, on average, takes only 20 days to collect payments from customers starting from the sale date.
Why Is DSO Important?
A company’s DSO is an indicator of the quality of its cash flow. The lower the DSO number, the less time it takes for cold hard cash to get back into company hands.
Because cash fuels operations, the importance of maintaining a low DSO is a no-brainer. A high DSO number reveals a payment collection performance issue. If a company isn’t receiving its cash on time, it won’t maintain a healthy cash flow.
Actively keeping track of your Days Sales Outstanding provides numerous benefits, including a clear snapshot of your company’s overall performance.
1. DSO Tracks Performance
Your DSO can give you a good glimpse of how well your company performs in many of its critical aspects. A low DSO hints at many positive performance signals, including:
- A sound collection process
- A proactive A/R management team
- An effective A/R strategy
- High customer satisfaction
- Lower risk of cash burnout
- Healthy overall cash flow
2. DSO Reveals Cash Flow Issues
If you notice that your firm’s DSO has been on the rise, period-over-period, it could be a tell-tale sign of an upcoming cash crunch. A company must keep paying its bills, ideally on time. A poor cash flow may result in your company failing to meet its obligations, let alone pay expenses. Your DSO can help you keep tabs on your cash flow performance, allowing you to remain proactive.
3. DSO Resolves Problems Before They Grow
If you’ve dealt with accounts receivables before, you’ve probably seen firsthand how crucial it is to convert those receivables to cash as quickly as possible. Keeping a close eye on your DSO means that you can spot issues as they arise and make the necessary efforts to mitigate them. DSO is often analyzed in trends. If you’re noticing a steady increase, it may be time to bolster your A/R management. Resolving your cash flow problems before they become big is vital if you want your business to stay afloat.
4. DSO Can Measure Customer Satisfaction
Your efficiency at closing out transactions on credit can be a direct reflection of how happy your customers are with your products or services. A low DSO might indicate, to a degree, a high customer satisfaction rate. If your customers are happy with the value you bring, they’ll be more likely to pay on time.
How Do You Reduce DSO?
Improving your company’s DSO not only involves your credit and collection or accounting departments. It’s going to be a company-wide effort. Generally, a DSO below 45 is considered to be suitable for most companies. However, this benchmark may vary between different industries.
We’ll walk you through how you can reduce your Days Sales Outstanding so you’ll always have enough cash to fuel your business.
1. Get Your Invoicing Right
The efficiency of your accounting process plays a vital role in your DSO performance. Flawed invoicing can harm your payment collection efforts. Your accounts department should have a laser focus on creating an exemplary streamlined invoicing process to save you from dreaded delays.
Getting your invoicing right means ensuring that every invoice going out contains all necessary information and is free from errors. You also want to ensure that everything on it is easy to digest since confusion can delay payments. There’s a lot of things that could go wrong with misinformation. Incorrect charges and discounts can turn customers off, or worse.
On-time invoice deliveries can also go a long way in avoiding delays. You don’t want to suffer a setback just because an invoice didn’t make it out on time. Just make sure that you’re mailing to the correct address.
2. Evaluate Your Customers
Your company’s credit policy dictates the terms that customers can repay their balance. One of the benefits of having a lenient credit policy is that you can encourage more sales. However, if a reasonable collection rate is what you’ll have to give up for having better sales, you might want to rethink your strategy.
The best way to evaluate your customers is to set up ideal criteria for an acceptable customer risk. Based on these criteria, you can determine if a new customer presents a chance of being a problematic payer. You can also apply these criteria to existing customers, particularly those who are slow in making payments.
After perfecting your credit terms, make sure that your sales team follows them by the book. Some of your salespeople might not be too keen on losing out on sales, even if it meant dealing with risky customers. To combat this natural tendency, you can implement specific consequences for breaking the rules.
3. Make It Easier For Customers to Pay You
You want to make customers feel special, but having a track record of satisfied customers isn’t enough to keep your business healthy. One of the best things that you can do to reduce DSO is to make it easier for customers to pay. Offering flexible payment methods such as credit card payments can make it convenient for customers to pay.
Communication is key when it comes to transactions that involve credit. Keeping contacts open can strengthen your relationships with your customers and encourage them to pay on time. You can take communication a step further by providing your customers with options to view their statements and invoices online.
4. Bolster Your Accounts Receivable Management Strategy
Making a sale isn’t the end of the story. After sending out an invoice, you’d want to ensure it doesn’t remain unpaid too long. An effective A/R management strategy can help you keep tabs on every outstanding balance and take the necessary steps to collect them.
Focus on having a good follow-up plan in place whenever customers get late on their payments. As with many other facets of your business, communication is vital in managing accounts receivables. Apart from getting in touch with slow-paying customers and settling disputes, it would help if you also encourage them to communicate their problems. Doing so allows you to determine if their situation is eligible for special payment arrangements. Providing a unique payment plan may not be ideal, but it’s better than dealing with a prolonged payment default.
All of this process can also get automated so that the finance teams no longer need to worry about unpaid invoices and costly errors.
If worse comes to worst, having a straightforward guideline can save you from a lot of headaches. For example, you might include a policy for turning over a delinquent account to a collection agency.
Providing incentives for early settlements prove that you value your customers. It could also motivate your customers to pay earlier than they normally do. Incentives can take the form of early payment discounts or just downright slashing off your prices right off the bat for repeat customers.
For example, you could offer a discount when a customer pays within 15 days for a 1-month payment term. If you think it may not be worth it, think about how the early incoming cash could help pay off some of your expenses.
What are the Other Metrics to Analyze Along with the DSO?
While DSO calculations help optimize A/R, they still leave room for assumptions. That’s why it’s best to consider other factors for a clear picture. Besides, these factors help the senior management detect error-prone areas and formulate an action plan to eliminate them.
1. Collections Effectiveness Index (CEI)
As the name suggests, CEI measures how effective the collections team and their procedures are. Acknowledged as one of the best metrics to consider along with DSO, you can interpret the order-to-cash teams’ performance.
2. Bad Debt to Sales
Bad debt occurs when customers can’t pay their dues, and this metric shows how much is written off. This is measured in ratio, and if it increases with time, it suggests weak credit policies and management.
3. Days Deduction Outstanding
DDO or Days Deduction Outstanding is a metric calculated to clarify how a business deals with its deductions. DDO is calculated by dividing the outstanding deductions by the average deductions in a certain period. The period could be three, six, or 12 months.
4. Accounts Receivable Turnover Ratio
A crucial metric to gauge how a business manages and collects its assets. We recommend aiming for a high A/R turnover ratio as it indicates process efficiency.
5. Best Possible Days Sales Outstanding
This metric defines the best possible number of days it takes for a business to collect its receivables. It’s theoretically calculated for an internal comparison between the DSO and BPDSO. Based on this, the senior management establishes the best method for benchmarking AR.
Use the Right Tool For Your Collection Process
It’s almost impossible to reduce DSO with having slow manual processes in place.
Every component of your business should have a sound process in place, and your collections are no different. The systems you employ when collecting money owed will determine how well you can improve cash flow.
Apart from providing the proper training, equip your teams with the right tools to improve their collection performance. Opting for a full-service accounts receivable software can streamline your collection processes from invoices to cash receipts.
A great platform can provide all the tools you need, from workflow automation to integrated payments to customer portals. The added automation adds convenience and flexibility for both your team and customers.
Getting exceptional accounts receivable software not only aids you in reducing DSO. Ultimately, it saves you time, money, and resources by allowing you to work smarter and faster.
Growing a business takes a lot of hard work. To guarantee your business’ growth, you must focus on one of its most essential drivers — cash flow. Properly managing your cash flow can ensure that it stays on the right track.
Reducing DSO is one of the most effective approaches to improving your business’s finances. Though it may seem complex at first, improving your DSO takes only a few key steps. By facilitating teamwork and implementing the right tools, you’ll ensure good results coming your way.
Streamline Your Accounts Receivable Processes
Peakflo allows you to streamline all of your accounts and collection processes under one high-performing digital platform. We offer features that help you increase your A/R team’s productivity and make it easier for customers to pay you on time.
Big or small, we’ll provide you with a complete picture of your company’s finance.
Connect your accounting software with Peakflo today and start automating your accounts receivables!