Days Sales Outstanding (DSO): Meaning in Finance, Calculation, and Applications

What Is Days Sales Outstanding (DSO)?

Days sales outstanding (DSO) is a measure of the average number of days that it takes a company to collect payment for a sale. DSO is often determined on a monthly, quarterly, or annual basis.

To compute DSO, divide the average accounts receivable during a given period by the total value of credit sales during the same period, and then multiply the result by the number of days in the period being measured.

Days sales outstanding is an element of the cash conversion cycle and may also be referred to as days receivables or average collection period.

Understanding Days Sales Outstanding (DSO)

Given the vital importance of cash flow in running a business, it is in a company's best interest to collect its outstanding accounts receivables as quickly as possible. Companies can expect, with relative certainty, that they will be paid their outstanding receivables. But because of the time value of money principle, time spent waiting to be paid is money lost.

That said, the definition of "quickly" depends on the business. In the financial industry, relatively long payment terms are common. In the agriculture and fuel industries, fast payment can be crucial. In general, small businesses rely more heavily on steady cash flow than large, diversified companies.

$\begin{aligned}&\text{DSO} = \frac {\text{Accounts Receivable} }{ \text{Total Credit Sales} } \times \text{Number of Days}\\\end{aligned}$​DSO=Total Credit SalesAccounts Receivable​×Number of Days​

What the Numbers Tell You

A high DSO number shows that a company is selling its product to customers on credit and waiting a long time to collect the money. This can lead to cash flow problems. A low DSO value means that it takes a company fewer days to collect its accounts receivable. That company is promptly getting the money it needs to create new business.

In effect, determining the average length of time that a company’s outstanding balances are carried in receivables can reveal a great deal about the nature of the company’s cash flow.

It is important to remember that the formula for calculating DSO only accounts for credit sales. While cash sales may be considered to have a DSO of 0, they are not factored into DSO calculations. If they were factored into the calculation, they would decrease the DSO, and companies with a high proportion of cash sales would have lower DSOs than those with a high proportion of credit sales.

Applications of Days Sales Outstanding

Days sales outstanding can be analyzed in a wide variety of ways. It suggests how efficient the company's collections department is, and the degree to which the company is maintaining customer satisfaction. It also helps identify customers who are not creditworthy.

Looking at a DSO value for a company for a single period can provide a good benchmark for quickly assessing a company’s cash flow. However, trends in DSO over time are much more useful. They can act as an early warning sign of trouble.

Good and Bad DSO Numbers

If a company’s DSO is increasing, it's a warning sign that something is wrong. Customer satisfaction might be declining, or the salespeople may be offering longer terms of payment to drive increased sales. Perhaps the company may be allowing customers with poor credit to make purchases on credit.

A sharp increase in DSO can cause a company serious cash flow problems. If a company's ability to make its own payments in a timely fashion is disrupted, it may be forced to make drastic changes.

Generally, when looking at a given company’s cash flow, it is helpful to track that company’s DSO over time to determine if its DSO is trending up or down or if there are patterns in the company’s cash flow history.

DSO may vary consistently on a monthly basis, particularly if the company's product is seasonal. If a company has a volatile DSO, this may be cause for concern, but if its DSO regularly dips during a particular season each year, it could be no reason to worry.

Limitations of Days Sales Outstanding

As a metric attempting to gauge the efficiency of a business, days sales outstanding comes with a limitation that is important for any investor to consider.

When using DSO to compare the cash flows of a number of companies, you should compare companies within the same industry, with similar business models and revenue numbers. If you try to compare companies in different industries and of different sizes, the results you'll get will be misleading because they often have very different DSO benchmarks and targets.

When DSO Is Not As Relevant

DSO is not particularly useful in comparing companies with significant differences in the proportion of sales that are made on credit. The DSO of a company with a low proportion of credit sales does not indicate much about that company’s cash flow. Comparing such companies with those that have a high proportion of credit sales also says little.

In addition, DSO is not a perfect indicator of a company’s accounts receivable efficiency. Fluctuating sales volumes can affect DSO, with any increase in sales lowering the DSO value.

Delinquent Days Sales Outstanding (DDSO) is a good alternative for credit collection assessment or for use alongside DSO. Like any metric measuring a company’s performance, DSO should not be considered alone, but rather should be used with other metrics.

The Bottom Line

In many businesses, the days sales outstanding number can be a valuable indicator of the efficiency of the business and the quality of its cash flow. If the number gets too high, it could even disrupt the normal operations of the business, causing its own outstanding payments to be delayed. In any case, cash delayed is cash lost to your business.