What is DSO, how to calculate DSO, and why?

(This blog was first published on https://icontroller.org/en/dso)

Every company, sooner or later, deals with unpaid or overdue invoices. If you do not intervene in time when they continue to accumulate, it will have serious consequences for your company. Do you want to find out whether the status ‘alarming’ or whether your efforts to shorten payment terms have had any effect? Then, fortunately, there is a handy measuring instrument with which you can easily check this: DSO or “Days Sales Outstanding”.

What does DSO mean?

DSO is an abbreviation that stands for Days Sales Outstanding. It indicates how many days on average it takes for a company to receive an invoice after having delivered a product or service. The DSO ratio provides a clear picture of a company’s cash flow and liquidity position, and thus of its health. It is the most widely used measurement tool for credit management and debtor management.

What is the importance of good DSO?

Companies have every interest in good DSO. If a company still needs to receive cash for products or services it has delivered, this is a loss that should not be underestimated. After all, every euro that has yet to be received cannot (yet) be invested.

A good DSO is therefore a low DSO. With a low DSO, invoices are paid quickly, which is conducive to a company’s cash flow and liquidity position.

DSO and payment terms

Payment terms of invoices, of course, also have their impact on DSO. As long as the DSO ratio remains at or below the payment term of invoices, there is no problem. Even a few days past the deadline should not immediately concern. But if the DSO ratio is well above the payment term, problems can arise. This can happen, for example, when a company has a debtor portfolio that is too risky, or when it does not pursue a (good) debtor policy. The cash flow of a company is negatively affected by this — and that says a lot about the financial health of a company.

DSO calculation example

There are different ways to calculate the DSO ratio. The simplest and most frequently used way is to divide the end-of-month debtor balance by the monthly turnover and multiply the result by 30.

Example of DSO calculation:

(End-of-month debtor balance / Monthly turnover) x 30 = average payment term in days

For a quick inventory, you can also divide the debtor balance by the average monthly turnover (annual turnover/12) instead of the monthly turnover. With the quarterly method you replace the monthly turnover with the average quarterly turnover.

How to lower DSO?

How to reduce the DSO ratio? This can be achieved in the first place by means of sound preparatory work. By thoroughly examining the creditworthiness of potential customers, you reduce the risk of default.

In addition, a good follow-up of your invoices is particularly important. Software such as iController is available for this purpose: it helps to make the right decisions in credit management.

Weaknesses of DSO

The DSO ratio is sometimes criticized. The biggest weakness is that the calculations are based on averages. Large and small amounts and payment terms balance each other out, which is why the DSO ratio can sharply fall or rise in the event of short-term changes, and is therefore not a safe way to check whether a company is healthy.

A second point of criticism: no matter how good your DSO ratio is, there is no guarantee whatsoever that a customer who pays on time today will do so tomorrow. Therefore, DSO says little about the future of payment behavior.