A small business needs cash to operate, and that cash often relies on your customers paying you in a timely manner. That’s where the days sales outstanding (DSO) formula comes in. Your business’s DSO value tells you the average number of days it takes to get paid for a credit sale. In this article, we break down how to calculate DSO and why it matters for your small business.
What Is Days Sales Outstanding (DSO)?
Days sales outstanding is a financial ratio that tells you the amount of time it takes your business to get paid for a sale, on average. It’s also called days receivables and average collection period.
Calculate your days sales outstanding ratio by dividing your average accounts receivable during a period of time by your total credit sales during that same time and then multiplying that answer by the number of days. The day sales outstanding formula is part of the cash conversion cycle. You can look at a company’s DSO monthly, quarterly, or annually.
Understanding Days Sales Outstanding
Your small business’s average DSO shows how long it takes you to collect payment for credit card sales over time. Cash sales aren’t worked into the DSO calculation since you get paid for those upfront.
A lower DSO is a positive sign that you’re getting paid quickly and can add it to your working capital sooner. A higher DSO, on the other hand, means your customers are taking longer to pay you. If a DSO ratio continues to climb over time, it could lead to serious cash flow problems for your business.
Why Is DSO Important?
Using the DSO formula can give you a clearer idea of the overall financial health of your small business. Your company’s cash flow is essential for running your business. The finance principle known as the time value of money means money in your hand today is worth more than money you obtain in the future.
Calculating your DSO value helps you figure out:
- How long it takes you on average to get paid
- How many sales you made during a period of time
- If there are any issues with how you’re collecting payments
- The potential for future cash flow issues where you are struggling to pay your bills
- If you need to cut out any of your customers because the collection process is a struggle
So having a low DSO value is essential for a successful business because it means you’re getting paid more quickly, and a high DSO means the opposite.
What DSO Means for Your Business
If you’re a new business or business without excessive cash flow, tracking your DSO can stop you from endangering your business’s bottom line. A DSO trending upward means your customers are taking longer to pay. This could be because your sales team is offering products to customers with bad credit or they’re incentivising customers with longer payment terms. It could also mean your customers are less satisfied with your service.
If it’s trending downward, it means the opposite: Your customers are paying quickly and you have more cash on hand to use to grow your business. And if it varies, it may not be an issue if your business is seasonal and the variations are similar year-over-year. But if your business isn’t seasonal, a varying DSO is worth looking into to see if there are any issues you can fix.
Good and Bad DSO Numbers
A DSO value less than 45 days is great — it means your customers pay you within an average of 45 days. But a good DSO vs. a bad DSO depends on your industry. Industries like finance have longer payment periods than the agricultural sector, for example, and will affect different types of businesses in a variety of ways.
If your DSO is higher than you’d like, there are a few things you can try:
- Ask your customers to pay upfront. You might be surprised that many customers are fine with paying right away. Early payments can help bring your DSO down.
- Incorporate easy payment methods. Your customers are also busy, so make sure it’s not a multi-step process to pay you. Consider offering online payments to make things smoother.
- Review your credit policy. You may want to be more careful of who you offer credit to. Checking your customer’s credit score can give you a good idea of whether or not they’re likely to be late on payments.
Example of DSO
Let’s look at two examples of DSO for a fictional company, Company ABC, so you have a better understanding of how to calculate DSO. You can find these numbers by looking at the company’s financial statements.
The formula for DSO is:
Average accounts receivable balance during time period ÷ total value of credit sales during time period x number of days
During the month of March, Company ABC makes $25,000 in credit sales and $10,000 in accounts receivable. To find the DSO for the 31 days in March, the equation would look like this:
$10,000 ÷ $25,000 x 31 = 12.4
So the DSO value for Company ABC during March is excellent at 12.4. This means it took less than 13 days to get paid in March.
When to Use DSO, and When Not to Use It
You don’t want to use DSO by itself. Instead, use the calculation with other accounting metrics like turnover ratio to give you a fuller picture of how your company is performing.
You’ll also want to track DSO over time. If you look at the number each month, it will give you a good idea in real-time if your payments are lagging behind and if your receivable process is working. Then you can use this information to make adjustments or improvements to help get your money quicker.
However, a company that uses credit for most of or very little of its sales would likely not benefit from calculating its DSO value — it doesn’t represent the true cash flow of the company.
How Do You Calculate DSO?
The DSO equation is dividing the average accounts receivable during the time period by the total value of credit sales during the time period. Then multiply the result by how many days are in the time period.
What Is a Good DSO Ratio?
A good DSO value is less than 45 because it means it takes your customers an average of under 45 days to pay you. The exact definition of a good DSO depends on which industry you operate in, however, since quick payment is more vital to some industries than others.
How Do You Calculate DSO for Three Months?
If you want to look at a DSO over three months, add up the number of days in those months. For example, if you’re looking at the end of the year, October has 31 days, November has 30 days, and December has 31 days. That’s 92 days total, which you’ll input into the formula for the number of days.
A Lasting Solution to Cash Flow Issues
We know that not having enough cash for your business can keep you up at night. If you’re struggling with cash flow problems caused by a high DSO (or that wouldn’t be solved by your customers paying more quickly), Nav is here to help. There are many funding options that you may qualify for, like small business loans or credit cards. Create your free Nav account to see what options are out there for your business.