Learn about Daily Sales Outstanding MetricScott Williams
cashflow is the life blood of a business but it is a difficult thing to grasp as an abstract idea. “Is my cashflow OK?” is difficult to answer. Effective management of Accounts Receivables is part of the answer. The Accounts Receivable Daily Sales Outstanding (DSO) ratio, and its partner, the Daily Accounts Payable Outstanding (DPO) ratio respectively measure how many days it takes to collect the money owed to you and the days it takes for you to pay your suppliers. If DPO is more than DSO, you are paying suppliers slower than you are getting money from your customers and you are in a positive position. It also means you can fund your growth (to at least some extent) from sales. If the DSO is larger than the DPO, you are paying suppliers before you collect from your customers so you will need an overdraft and may actually run out of cash in the foreseeable future. Also, you will not be internally generating sufficient money to pay for your growth and will need to find other cash sources for that.
These two ratios should be key metrics on your dashboard so that you can rapidly see if cashflow is becoming unhealthy.
Read this if: you are in business! Seriously, understanding your cashflow is a basic necessity for a business. These two ratios help explain your current position and trends.
Relies on: the use of ‘Dashboards’ to monitor company-critical information.
Degree of Difficultly: yellow belt (entry-level).
Daily Sales Outstanding Metric
One of the things that we want to keep an eye on is whether we are managing our Accounts Receivable effectively. This is an important part of good cashflow management. And good cashflow is vital for you to be able to pay bills as they fall due. You should have the Accounts Receivable Daily Sales Outstanding (DSO) Metric as one of your key metrics on your dashboard so that you can rapidly see if this figure deteriorates.
Daily Sales Outstanding (DSO) Calculation
The DSO is a simple figure to calculate.
Step 1. Calculate your Average Daily Sales:
Take last month’s Revenue x 12 (for a full year) and then divide by 365.
This gives you an estimated Average Daily Sales figure over a year.
You could use a longer period, such as a quarter, instead of or as well as, a month.
The longer periods will tend to smooth out seasonal fluctuations – like Summer versus Winter sales – but the disadvantage is that feedback on weakening Accounts Receivable will be delayed to 90 days instead of 30 days.
Step 2. Calculate your DSO:
Take the End of Month’s Accounts Receivable balance, that should be in your Company Balance Sheet, and divide it by the Average Daily Sales.
This will give you a figure that tells you roughly how long your Accounts Receivable are outstanding.
End of Month Accounts Receivable balance = $1,000
Average Daily Sales = $100
Calculation – $1,000/$100 = 10 days.
Indicates that you have an average of 10 days of Accounts Receivable outstanding.
The DSO will track changes in Income automatically. If revenue goes up, our Average Daily Sales figure will automatically go up as well.
Seasonal variation in revenue can distort these rather simplistic calculations.
For example, Revenue in a beach side tourist business might be higher in summer than winter and therefore the Accounts Receivable might be higher in a good season.
If seasonality is likely to be high in your industry, try comparing your DSO with the same month last year rather than the recent, previous, month. This will measure “like with like”.
Assume we sold $50,000 in a month.
$50,000 x 12 = $600,000 divided by 365 = $1,644.
This is the Average Daily Sales Outstanding (DSO).
Assume we have $40,000 in Accounts Receivable at the end of the month.
$40,000 divided by $1,644 = 24.3 days of Daily Sales Outstanding.
Interpreting the DSO
Using single estimates
How can we tell whether 24.3 days of Daily Sales Outstanding, from the example above, is good or bad?
Let us look at an obvious bad example:
Your Daily Sales Outstanding is 120 days but your supplier’s terms of trade are 30 days. You are required to pay your invoice within the 30 days or they may cut you off. You are financing (120-30) 90 days of your Accounts Receivable; not a good position to be in. If you are in the unhealthy position of money coming in well after you are required to make payments, you will need to draw down an overdraft or find another source of income to cover this gap. You are losing interest on your deposited funds or paying interest on an overdraft as a consequence. In a fairly short period of time you may be bust!
So, referring back to our example from above of 24.3 days, if your payment terms with your suppliers is greater than this, you are paying for your saleable products from your own cashflow which is good and healthy. If you have to pay your supplier in less than 23 days, your cashflow needs your attention.
At the minimum, we want a DSO approximately the same or (better) less than your frequency of paying your suppliers. Either improve the DSO and/or slow down payments to suppliers.
In an alternative, happy scenario, if you are able to have your customers pay for a product before you have to pay the supplier, you will have a negative (very good) DSO. Dell Computers was famous for this for many years. People ordered online and paid immediately, Dell paid its suppliers on normal terms meaning it had the buyer’s cash in-hand well before paying the suppliers. Something to aim for since all the growth in your company can then be paid for using the supplier’s money that you are holding until you have to pay them.
Assume that the Accounts Receivable moves from $40,000 to $50,000 (that is, it gets larger and more to collect).
Let’s also assume there has been no change in the Average Daily Sales of $1644 from the example above.
$50,000 divided by $1,644 = 30.4 days of Accounts Receivable.
If we subtract the previous 24.3 days from the present 30.4 days, we can see that our Accounts Receivable has weakened by 6 days.
We are interested mainly in the trend from month to month or quarter to quarter. In this example, it worsened by 6 days in the course of a month so alarm bells would be going off by now.
If the DSO begins to increase, it means that we are becoming less effective at collecting our Accounts Receivable. We are taking more days to get the money back. In turn this means your cashflow will deteriorate and your ability to grow the company will also deteriorate. You might find it increasingly difficult to pay your bills on time.
This is an automatic indicator that we need to jump onto the Accounts Receivable process and get that figure heading back in the right direction, otherwise we are in trouble with cashflow and consequently with growth.
Measuring Daily Accounts Payable Outstanding
You might have a rule about when you pay your suppliers. Possibly you pay them in 30 days or when they shout at you down the phone. In this case, you have a fairly good idea if you are funding your business within your DSO.
If you want a more scientific approach, you can do the same thing with Accounts Payable, as you did with Accounts Receivable, to give you the DSO.
Take your end of month amount paid to suppliers in the course of the month, multiply by 12 months and divide by 365 days.
Assume we pay suppliers $35,000 a month for the product necessary to make the $50,000 in sales in the above example.
$35,000 x 12 = $420,000 divided by 365 = $1,150
This is the Average Daily Payments Outstanding
Assume we have $27,000 in Accounts Payable at the end of the month.
$27,000 divided by $1,150 = 23.4 days of Accounts Payable (days to pay suppliers).
In this example:
Our Accounts Receivable are taking 24.3 days to come in and we are paying our Accounts Payable in 23.4 days.
We are paying out faster than it is coming in; an unhealthy situation.
Dashboarding your DSO
Because the Daily Sales Outstanding is such an important indicator of the heath of your business’ cashflow, we encourage you to calculate it monthly and to put it into your Dashboard (see the Dashboard article).
Ideally, you should share the Dashboard with your Accounts Receivable and Accounts Payable staff so that they can monitor their own performance. A useful way to drive it home would be to get them to calculate it for you, but always do spot checks on their calculation to ensure they are feeding you correct information.
Other useful Articles on cashflow
12Faces considers a thorough grasp of your cashflow picture to be vital to the health of your business.
For this reason, there are several articles on various aspects of cashflow that will be valuable further reading.
We have collected these in the cashflow Menu.