Everything about Mastering Days Sales Outstanding (DSO)

Imagine you own a thriving graphic design agency in Chicago. Business is booming, with a growing client list and projects rolling in.

But there’s a catch - your cashflow isn’t keeping up.

You’ve completed $50,000 worth of work this month, yet your bank balance doesn’t reflect it.

If this sounds familiar, it’s time to take a closer look at your Days Sales Outstanding (DSO).

Managing a business, whether it’s a tech startup in Silicon Valley or a family-owned manufacturing firm in the Midwest, involves navigating a complex financial landscape.

One key metric that can make a significant difference in how you handle cashflow challenges is the accounts receivable efficiency.

Understanding this concept can help you better manage your finances and ensure a healthier cash flow.

In this quick guide, we’ll break down how to optimize your DSO.

You’ll learn how to calculate this essential metric, grasp its impact on your business, and most importantly, use it to your advantage.

Mastering this financial tool can be the difference between just making payroll and confidently scaling your operations.

What is Days Sales Outstanding (DSO)? 

Days Sales Outstanding (DSO) is a financial metric that measures the average number of days it takes for a company to receive payment from its customers after a sale.

Also referred to as days receivables or the average collection period, DSO is a critical component of the cash conversion cycle (CCC) and can be calculated on a monthly, quarterly, or annual basis.

This ratio provides essential insights into the efficiency of a company’s accounts receivable management.

Generally, a high DSO indicates delays in payment collection, which can result in cash flow challenges.

Conversely, a low number suggests that the business is collecting payments promptly, enabling it to reinvest funds more effectively.

For example, consider Elmo Tech, which recently secured a $100,000 software deal.

If the DSO is 45 days, it means the tech business waits a month and a half to receive payment.

A lower DSO - such as 20 days - indicates quicker payment collection, providing the company with the cash it needs to reinvest in growth or new opportunities. 

Conversely, a higher DSO, say 60 days, may signal potential issues, as delayed payments can restrict cash flow and limit financial agility.

This example illustrates how effective DSO management is crucial for maintaining healthy cashflow, ensuring your business remains agile and competitive.

Why DSO matters: strategic insights for SMB owners

Understanding days receivables provides a comprehensive view of the company’s financial health.

This ratio measures how efficiently a business converts its sales into cash, reflecting the effectiveness of its collections process. A healthy number indicates: 

1. Cashflow control

According to a study performed by Jessie Hagen of U.S. Bank quoted by Business Insider, 82% of small businesses fail due to cash flow problems.

That’s why keeping it at a healthy level is vital.

A low DSO ensures predictable and steady resources, enabling businesses to meet obligations, pay employees on time, and invest in growth initiatives. 

Conversely, a high average collection period can strain liquidity, forcing the company to scramble for cash or miss out on key opportunities.

2. Accounts receivable efficiency

DSO serves as a powerful metric for assessing the efficiency of accounts receivable processes.

A lower DSO indicates a streamlined operation where payments are collected promptly, enhancing cash management.

In contrast, a high DSO highlights inefficiencies that may require strategic adjustments to improve cashflow.

3. Customer payment behavior

Days Sales Outstanding also offers valuable judgments into customer payment behaviors.

An increasing number might suggest that clients are facing financial difficulties or that credit terms are too lenient.

This metric signals the need for potential adjustments to safeguard the business’s financial stability.

By prioritizing DSO, business owners can ensure financial agility and resilience, making informed decisions that enhance overall business performance.

How to calculate DSO?

Calculating Days Sales Outstanding is straightforward and essential for monitoring your financial health.

Here’s the formula: 

Let’s break down the process with a step-by-step practical example:

1. Determine your Accounts Receivable (A/R): start by identifying the total amount your customers owe you. For instance, if your A/R is $80,000, this represents the total value of unpaid invoices.
2. Calculate your total credit sales: next, define the total sales made on credit during a specific period. For example, let’s say your total credit sales for the month are $200,000.
3. Select the time period: choose the period for which you’re calculating DSO, commonly 30 days.
4. Apply the formula: 80.000 / 200.000 x 30 = 12.

In this scenario, it takes your business an average of 12 days to collect payment after a sale, indicating efficient financial management.

What exactly is a good DSO?

One of the most frequent questions business owners ask is: "What should our Days Receivable ratio be?"

The answer isn’t universal, since it depends on your industry, business model, and customer base.

However, here are some general benchmarks to guide you:

• Low DSO (under 30 Days): generally considered excellent. It suggests that your business is getting paid quickly, maintaining strong cash flow.
• Moderate DSO (30-45 Days): this range is acceptable, especially in industries where extended credit terms are standard. It indicates a reasonably efficient collection process.
• High DSO (over 45 Days): this could be a red flag, signaling potential cashflow issues due to slow collections.

To put these benchmarks in perspective, consider the following industry-specific examples:

• Retail business: retailers often experience low DSO, typically under 20 days, because sales are frequently made in cash or through quick-turnaround credit. A sudden rise in DSO could signal issues with bulk or wholesale customers delaying payments.
• Manufacturing company: manufacturers might have a DSO around 40 days due to longer credit terms common in this sector. However, if DSO exceeds 50 days, it may be time to re-evaluate credit terms and collection processes.
• Service-based business: for service-oriented SMBs, like marketing agencies, a DSO of 30-40 days is typical. If it stretches beyond 45 days, it could indicate problematic payment terms or inefficient invoicing.

Where does your business stand? Understanding your average collection period in the context of your industry can help you make informed decisions to optimize your financial health.

6 related concepts to monitor alongside DSO

While Days Sales Outstanding is a vital metric for assessing your accounts receivable efficiency, it doesn’t tell the whole story.

To gain a comprehensive view of your financial health and identify areas for improvement, it’s essential to analyze related ratios that complement the average collection period. 

1. Bad Debt to Sales Ratio

Tracks the portion of sales that must be written off as bad debt.

An increasing ratio suggests that your credit policies may be too lenient or that collections practices need tightening.

Monitoring this metric alongside DSO helps ensure that efforts to reduce it don’t inadvertently lead to higher bad debts.

2. Collections Effectiveness Index (CEI)

Measures the efficiency of your collections team and processes. It offers deeper insights into how effectively your team is turning receivables into cash.

A high CEI indicates strong performance, while a lower one may signal the need for process improvements or additional training.

3. Days Deduction Outstanding (DDO)

This ratio measures how efficiently your business handles deductions.

It’s calculated by dividing outstanding by the average deductions over a set period, such as three, six, or 12 months.

A lower DDO indicates that your company is effectively managing deductions, complementing a low DSO for optimal cash flow.

4. Accounts Receivable Turnover Ratio

Shows how often your business collects its receivables during a specific period.

A high turnover ratio reflects efficient processes and a well-managed receivables function, aligning with a low DSO to indicate overall financial health.

5. Best Possible Days Sales Outstanding (BPDSO)

Theoretical metric that defines the shortest time it should take to collect receivables under optimal conditions.

Comparing BPDSO with your actual DSO can highlight gaps in your processes and guide strategies for improvement.

6. Cash Conversion Cycle (CCC)

Finally, this ratio measures how long it takes for a company to convert its investments in inventory and other resources into cash flows from sales.

As we’ve mentioned before, DSO is a crucial component of CCC, along with Days Payable Outstanding (DPO) and Days Inventory Outstanding (DIO).

Top 4 tactical moves for optimizing your DSO

Balancing your Days Sales Outstanding is essential for maintaining healthy cashflow and financial stability.

Whether your goal is to reduce or increase this ratio, these strategies can help you align your metrics with industry standards:

1. Encourage early payments

If you need to reduce DSO, consider offering discounts or incentives for early payments.

This not only motivates quicker cash collection but also fosters stronger customer relationships. 

On the flip side, if your number is too low and you want to extend it to align with industry norms, consider offering extended payment terms strategically.

This is specially efficient to trusted clients who consistently meet their obligations.

2. Regularly assess customer creditworthiness

Reducing days receivables often requires tightening your credit policies.

Regularly evaluate the creditworthiness of your customers to identify and mitigate risks associated with late payments. 

For businesses needing to increase the levels, it’s valuable to consider extending more lenient terms to well-vetted customers, enabling them to make larger purchases without immediate financial pressure.

3. Offer multiple payment options

Offering diverse payment methods can streamline transactions and boost customer satisfaction, potentially reducing your DSO.

However, if your ratio falls below industry norms, introducing additional payment alternatives could strategically lengthen it while maintaining healthy cash flow.

4. Implement automation tools

Investing in automation can dramatically improve your accounts receivable process, helping you maintain an optimal DSO.

Automated systems can send timely reminders, track payments, and enforce penalties for late invoices, effectively reducing the ratio. 

Alternatively, for companies looking to increase DSO, automation can facilitate flexible payment plans and extended terms.

This practice allows more control over cashflow while offering customer-friendly options.

By applying these strategies, you can fine-tune your metrics to align with industry standards, ensuring your business remains financially agile and competitive.

Strengthening your business through DSO mastery

You've now unlocked the power of DSO – but why stop there?

In today's business world, even optimal accounts receivable management may not be enough to seize every growth opportunity that comes your way.

This is where Stenn's cutting-edge invoice financing solutions become your strategic advantage.

You can turn your unpaid invoices into immediate working capital, allowing you to:

• Take on larger projects without cashflow worries
• Invest in new equipment or technology to stay ahead of competitors
• Expand into new markets without depleting your cash reserves

Don't let financial constraints hold your business back. Talk to our experts today to discover how our tailored financing solutions can complement your strategies. 

Partner with Stenn and transform your invoices into powerful growth catalysts. Your future success is just a click away – seize it now.