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Days Sales Outstanding (DSO): Understanding key business metrics
In the fast-paced world of business finance, understanding and managing key metrics can be the difference between success and stagnation. Among these metrics, Days Sales Outstanding (DSO) stands out as a critical indicator of a company's financial health and operational efficiency. This measure is more than just a number; it's a reflection of how quickly a business can turn sales into cash, directly impacting liquidity and growth potential.
In this post we explain the why, what and how of this important metric — before explaining how process mining can improve DSO ratios.
What is Days Sales Outstanding (DSO)?
Days sales outstanding or DSO is a crucial business metric and a KPI all accounts receivable teams should be tracking. It’s a measure of the average time (in days) companies take to collect payment for goods and services bought on credit over a given period. The lower your days sales outstanding ratio, the faster invoices are converted to money in the bank.
Why Days Sales Outstanding is important to your business
DSO is a key metric for business success because it’s a reliable barometer of cash flow — at both an individual customer and organizational level. Consequently it also helps businesses make more accurate cash flow forecasts. A high DSO figure (that extends well beyond payment terms) indicates that it’s taking too long to collect cash from customers. It’s indicative of poorer cash flow, with lower liquidity and reduced working capital to cover financial obligations and/or to invest for growth. You can’t spend what someone owes you.
Monitoring DSO enables businesses to identify and address problem payers in the customer base and serves as a reminder to stay on top of unpaid invoices. This presents great opportunities to enhance customer relationships as much as to accelerate payments.
Customers are often equally frustrated by any obstacles impeding smooth payment processes. Such impediments generate an expensive drain on admin resources on both sides of the payment fence and can hurt customer satisfaction. In this regard, DSO can also be used as an indicator of Accounts Receivable process efficiency. It flags opportunities to upgrade invoice-to-pay processes and provides a framework against which to measure the success of their execution.
Even seemingly modest improvements in DSO can have a significant impact on its overall performance. Take the example of healthcare innovator and Celonis customer IQVIA. Celonis helped them identify and address inefficiencies in their billing process, ensuring bills got out to customers and got accepted faster. "The average time of submission and acceptance has dropped dramatically" stated Michael Markman, VP, Head of Financial Shared Services at IQVIA. And given "one day of DSO is about $40M of free cash flow, [...] that’s been a big game-changer for us…"
Careful monitoring of days sales outstanding also serves as a listening post — tuned in to how market shifts or trends impact payment times. This data-driven early warning system provides timely, actionable insight from which to review Accounts Receivable strategies.
How to calculate Days Sales Outstanding
The two most common approaches to calculating your Days Sales Outstanding ratio are the Simple Method and the Countback Method. The Simple Method days sales outstanding formula is:
DSO = (Total Accounts Receivable / Total Credit Sales) x Number of days
So, if a business wanted its DSO for the 30-day month of June (a month in which accounts receivable finished on a million dollars with credit sales of two million) it would break down like this: ($1,000,000 / $2,000,000) x 30. In this instance the DSO is 15 days.
However, this approach doesn’t take into account any seasonality or sales fluctuations. Consequently many prefer the Countback Method, which goes back month-by-month incorporating gross sales and accounts receivable for each individual month. This DSO calculation compares the gross sales of a month with the accounts receivable from the same month. From here, two determinations are made:
If the value of accounts receivables is greater than gross sales then the number of days per month is added to the DSO value.
If gross sales are greater than the value of accounts receivables then calculate Account Receivable / Gross Sales x number of days in this month.
An example should make it a little clearer.
In October, the receivables are higher than sales so you add the DSO days and get a value of 31 because we start at 0.
In November, receivables are also higher than sales so you add the number of days of the month to the previous DSO value: 31 + 30 = 61
In December, sales are higher than receivables so calculate according to the DSO formula: DSO = $6,000 / $8,000 x 31 = 23.25 days
We add this value to the existing DSO value, which is now the final result: 61 + 23.25 = 84.25
What’s a good Days Sales Outstanding ratio?
In understanding Days Sales Outstanding (DSO), it's crucial to recognize that there's no one-size-fits-all number signifying excellent or poor accounts receivable management. This metric varies significantly across industries, influenced by distinct business models and payment practices. For instance, in 2021, the average DSO across various sectors was 40.6 days. Broadly speaking, a DSO ratio of 45 days or fewer is often seen as 'good' for most companies. However, what constitutes a high or low DSO can differ markedly depending on the specific industry and company type.
More importantly, the focus should be less on the absolute DSO number and more on its trend over time. A sudden increase in your DSO – for example, from 30 to 45 days – is a red flag. Such a shift indicates a potential issue in how efficiently your business is managing its receivables. It's not necessarily a cause for concern but certainly signal for closer examination and possible intervention. Consistency or improvement in DSO figures is generally more favorable than fluctuating or increasing trends.
The key takeaways here are:
A good DSO ratio differs from business to business — if you have sufficient liquidity to operate successfully, that’s a good start.
Monitor your DSO carefully.
Benchmark your DSO against sector norms.
Analyze DSO over time to determine trends and the efficacy of any process enhancements.
Irrespective of your current DSO ratio, it is always a good idea to seek improvements.
So what does outstanding look like in terms of days sales outstanding? The answer is, of course, it depends. It depends on your standard payment terms — if you allow net 60 day payments, for example, you’re unlikely to have a DSO ratio in the 20 to 30-day range. It also depends on any extensions to payment terms offered to larger customers.
Additionally, payment dynamics vary by industrial sector. JP Morgan’s Working Capital Index Report 2022 — which analyzes working capital metrics of the S&P 1500 — provides useful benchmarking that illustrates this DSO variance, for example:
How to improve Days Sales Outstanding
There are many factors that impact accounts receivable that in turn impact companies’ DSO ratios. Across people, systems, data, and processes there are challenges to overcome and opportunities to be realized. In Celonis’ report The State of Business Execution in 2021, for example, the three key issues faced by accounts receivable were found to be:
Rigid systems and technologies
Fragmented data landscape
Broken or inefficient processes
Such challenges result in late invoices, incorrect terms, invoice rejections, underpayments, late payments and non-payments. All of which push DSO in the wrong direction. But it’s one thing to know there are issues, and quite another to pinpoint where and why they occur or prioritize how they’re addressed. This is where process mining comes to the rescue.
1. Find what issues are impacting your DSO
Process mining is like conducting an ultra high definition MRI of business processes. Extracting, collating and aligning knowledge from event logs hidden behind every business information system, it forms a detailed, accurate visualization of how your accounts receivable processes are actually performing. A data-driven single source of truth for all business stakeholders from which to identify individual issues and any deviations from your ideal processes impacting your DSO ratio.
2. Find out why they are happening
Having identified potential opportunities for improvement, process mining enables you to dig into the underlying cause of the issues. It provides the data to understand, for example, whether payment delays are more frequent for particular client types, for specific services, in specific workflows, or in specific offices. With this information you can then investigate why these variables might be causing problems (such as errors in manual processes causing invoices to be rejected).
3. Prioritize how you address them
With this granular view of accounts receivable process issues (or opportunities), you have the data to quantify their impact on KPIs like your DSO ratio and cash flow. This not only establishes a clear order of priority when it comes to addressing them, but also underpins the business case for any investments required to optimize the processes.
A bright, high-def future for Days Sales Outstanding
Process mining can have a tangible impact on improving your DSO, shortening the period between invoice and payment. With the ability to visualize and optimize accounts receivable processes, you can pinpoint and address any areas of friction or inefficiency that add days to your DSO. You can measure the effectiveness of process enhancement.
Beyond that, you can gain new strategic understanding of customer payment dynamics and buyer behaviors to inform future customer targeting. All of which will contribute to shorter DSO ratios, enhanced cash flows, and ultimately an accounts receivable shift from cost centers to profit centers.
Bringing this future alive, the Celonis Accounts Receivable Premium Execution Apps combine process mining and artificial intelligence to enable data-driven AR management and start tangibly improving AR operations fast. Spanning collections management, credit management, and dispute management, these apps are designed to help companies optimize working capital through strong Accounts Receivable management.
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