Every industry has its own set of acronyms. Medicine has terms like ICU. The tech industry has IoT. And for anyone who deals with collecting customer payments, we have DSO.

Days Sales Outstanding, or DSO for short, is one of the most useful barometers for understanding a business’s financial health. If you’re new to DSO, read on to understand how it works and what it means for your business. And if you’re already a pro at calculating DSO (you are, right?), consider this a helpful refresher.

FIRST, WHAT EXACTLY IS DSO?

According to Investopedia, Days Sales Outstanding is…

A measure of the average number of days that a company takes to collect revenue after a sale has been made. A low DSO number means that it takes a company fewer days to collect its accounts receivable. A high DSO number shows that a company is selling its product to customers on credit and taking longer to collect money.

WHY SHOULD I CARE ABOUT DSO?

Cash flow is king; more cash = more resources to invest back into your business. If you’re not getting paid on time, that means less money you have on hand to make your business the best it can be.

Like gas prices, a lower DSO is always a good thing. It helps you make sense of your collections process and provides an easy metric to see if you’re getting better/worse at collecting from customers.

CALCULATING DSO: A SIMPLE EQUATION

DSO is typically calculated on a monthly basis. It’s good to get in the habit of calculating DSO regularly so you are able to spot trends and fluctuations in your accounts receivable. Here is how Investopedia recommends calculating DSO:

Accounts Receivable DIVIDED BY
Total Credit Sales TIMES
Number of Days [in the timeframe examined]

For example, let’s say at the end of July you have $600,000 that customers owe you. That’s your accounts receivable. You billed $1,000,000 during the month. That’s your total credit sales. And there are 31 days in July.

So, your A/R divided by total credit sales would be .6. Take that and multiply by 31, and we get your days sales outstanding. In this case, 18.6. Pretty good assuming payment terms are 30 days.

But what if, in the example above, our DSO turned out to be larger? Let’s say 60 days. That would be an unhealthy DSO and could mean a few things:

Stating the obvious, but you may not be managing your collections process in an optimal way
Your customers may be experiencing financial issues that are causing them to not be able to pay on time
Your industry or the economy at large may be going through a down cycle, so people are naturally taking longer than normal to pay
If you don’t have someone professionally managing your accounts receivable, it may be in your best financial interest to do so

DSO TIME SPAN: WHAT’S RIGHT FOR YOU?

In the above example, we illustrated how to calculate DSO on a monthly basis. However, that might not be the right time period depending on how your revenue flows. For example, if your revenue fluctuates from month to month, you may want to replace the Total Credit Sales and Number of Days with a longer period. Here’s two common examples:

EXAMPLE 1: DEREK’S BUILDING SUPPLIES

In the area where Derek’s Building Supplies operates, sales are quite seasonal. If Derek were to measure DSO using a monthly formula, he might get a misleading result when coming from a slow month into a busy month. His DSO might look unreasonably low because some of the amount in Accounts Receivable was left over from the prior month that was quite slow, but is measured against this month, which is quite busy.

If, however, Derek used annual amounts for Total Credit Sales and Number of Days, he would get a more consistent and realistic picture of his DSO and how it trends over time. In this case, the formula would be:

Accounts Receivable DIVIDED BY
Total Annual Sales TIMES
365

Rule of Thumb #1: In seasonal businesses, use an annual DSO calculation to provide a more consistent calculation and clearer trending.

EXAMPLE 2: PELLIGRINO VIDEO PRODUCTION

This lucky business happens to be growing rapidly. Sales this month were three times as much as they were in the same month last year, but still fluctuate from month to month. If Pelligrino were to use an annual DSO calculation, they would be comparing receivables that happened in recent months to sales numbers that were partially generated a year ago when it was a much smaller company. This would make the DSO look unreasonably high.

On the other hand, since sales are still fluctuating from month to month, a monthly DSO calculation might be misleading as well. The answer? Use the most recent 3 months as the benchmark period. These are new enough to be a good benchmark against current receivables, but long enough to mitigate month-to month fluctuations. The formula would be:

Accounts Receivable DIVIDED BY
Total Sales in the Last 3 Months TIMES
90

Rule of Thumb #2: In growing (or contracting) businesses, use a 3-month DSO calculation to provide a better basis for comparison and clearer trending.

LOOKING FOR TRENDS IN DSO

Although calculating your DSO at any given time gives you great information about the current state of your accounts receivable efforts, the magic really comes when you start to trend it. The ideal time to calculate DSO is on either the first or last day of the month. If you don’t already record your month-ending accounts receivable numbers, consider adding a calendar item on the first day of every month to remind you to capture it. Understanding how your DSO moves over time or in response to certain collections efforts can go a long way towards getting you paid faster!

Do you have a DSO story to share? Tell me about it in the comments below.