What it means
A sale on credit is not cash until the customer pays. Between the invoice and the receipt, the business has delivered the goods or service, incurred the cost, and is waiting; the receivable on its balance sheet is a loan to the customer.
Days sales outstanding measures the average length of that loan. For a business with $36,500,000 of annual credit sales, each day of DSO represents $100,000 of cash: reducing DSO by ten days releases $1,000,000, permanently, without changing a single sale.
That leverage is why the measure is a standard item in board packs and why credit control is a finance function rather than an administrative afterthought. The basic calculation divides the receivables balance at a date by the credit sales for the period and multiplies by the days in the period.
Cash sales must be excluded from the denominator, since they generate no receivable; including them understates DSO. The receivables balance should be trade receivables, gross of any bad debt provision, so that the provision does not flatter the figure.
The period should be long enough to smooth fluctuations but short enough to be current: a rolling three-month calculation responds to changes faster than an annual one, and businesses with seasonal sales should use the most recent months rather than an annual average, because a year-end receivables balance compared with a year's sales can be badly distorted by a strong or weak final quarter. A refinement is the countback method, which allocates the receivables balance against the most recent months' sales, working backwards until the balance is exhausted, and counts the days covered.
It corrects for the distortion of rising or falling sales and is preferred by credit managers for internal monitoring. A second refinement is best possible DSO, calculated using only the receivables that are not yet overdue; the gap between best possible DSO and actual DSO measures how much is attributable to late payment as opposed to the terms the business has chosen to offer.
If terms are 30 days and best possible DSO is 35, the sales pattern within the month explains the extra five days; if actual DSO is 60, late payment explains the other 25. DSO should be read with the ageing report, which splits receivables by how long they have been outstanding.
A DSO of 60 days against 30-day terms could mean that every customer pays at 60, or that most pay at 30 and a few very old balances drag the average up; the responses are different. The first calls for a review of terms and collection processes; the second for action on the specific old balances, which may be disputed invoices, customers in trouble or simply accounts nobody has chased.
Trend matters as much as level: a DSO drifting up while sales are flat means collections are slipping, and the cash shortfall arrives with a lag. Reducing DSO is rarely about being tougher with customers.
Most of the improvement in a typical business comes from invoicing faster and more accurately (an invoice raised ten days after delivery adds ten days to DSO before the customer has even seen it), from resolving disputes quickly so they do not block payment, from making it easy to pay, from systematic reminders before and immediately after the due date, and from setting and enforcing credit limits so that customers who do not pay cannot keep buying. Early payment discounts and factoring or invoice finance can reduce DSO too, at a cost that must be compared with the value of the cash released.
In practice
Real-world examples.
Example
A distributor with 30-day terms and a DSO of 33 is collecting almost exactly as agreed, and further reduction would require shorter terms that its competitors do not impose.
Example
A consultancy's DSO rises from 45 to 70 days over six months; the ageing report shows the increase is concentrated in one client that is disputing every invoice, and the issue is a contract problem rather than a collections problem.
Example
A manufacturer discovers that invoices are raised in a weekly batch, adding an average of three and a half days to DSO on $50,000,000 of sales, worth about $480,000 of cash for a change to daily invoicing.
Think of it
“DSO tells you how long money sits in customers' pockets after they've received your product-shorter is better for cash flow.
Formula
Calculation
Days sales outstanding = Trade receivables / Credit sales in period x Days in period
Best possible DSO = Receivables not yet overdue / Credit sales in period x Days in period
Cash value of one day of DSO = Annual credit sales / 365
Countback method: allocate the receivables balance against the most recent month's sales, then the month before, and so on; DSO is the number of days' sales covered
Worked example. A software services company has trade receivables of $6,000,000 at the year end and annual credit sales of $36,500,000. Its standard terms are 30 days.
- DSO = $6,000,000 / $36,500,000 x 365 = 60 days
- One day of DSO = $36,500,000 / 365 = $100,000
- Best possible DSO: $3,500,000 of the receivables are not yet due, so best possible DSO = $3,500,000 / $36,500,000 x 365 = 35 days; the remaining 25 days are late payment
Ageing of the $2,500,000 overdue: 1 to 30 days late $1,400,000; 31 to 60 days $700,000; 61 to 90 days $250,000; over 90 days $150,000.
Countback check. Sales in the last three months were December $3,600,000, November $3,000,000 and October $2,800,000. The $6,000,000 receivables balance covers all of December's sales ($3,600,000, 31 days) and $2,400,000 of November's $3,000,000 (0.8 x 30 = 24 days): countback DSO = 55 days. The countback figure is lower than the simple figure because sales rose towards the year end, which inflated the receivables balance relative to average monthly sales.
Value of improvement. Reducing DSO from 60 to 45 days releases 15 x $100,000 = $1,500,000 of cash. At an overdraft rate of 7%, that is $105,000 a year of interest saved, before counting the reduction in bad debts that usually accompanies tighter collection.Case study
Seen in the real world.
A manufacturer with annual credit sales of $73,000,000 ($200,000 a day) had run for years at a DSO of about 48 days against 30-day terms, holding about $9,600,000 of receivables. Over a year, with sales flat, DSO climbed to 71 days and receivables to $14,200,000, absorbing $4,600,000 of cash that the company had to borrow. The sales director blamed slow-paying customers and proposed a price increase to cover the financing cost; the finance director asked for the facts before agreeing.
The analysis found three causes, none of them customer behaviour. Invoices were raised on average twelve days after despatch, because the despatch paperwork went to the office by internal post and was keyed in batches; customers' 30 days did not start until the invoice arrived. Around $1,800,000 of the overdue balance was in dispute over pricing and short deliveries, and disputed invoices were not chased at all while the disputes sat unresolved with the sales team.
And the credit control function had lost a person and not replaced her, so reminders were going out sporadically. Best possible DSO, calculated on the receivables not yet overdue, was 38 days; the other 33 days were the company's own doing.
The fixes were operational. Invoices were generated from the despatch system at the moment of despatch, cutting the invoicing lag to zero and taking twelve days off DSO on its own. A dispute log was introduced with a five-day resolution target and a weekly review by the sales director, and disputed amounts were separated so that the undisputed part of each invoice could be collected.
The credit control vacancy was filled and a reminder cycle set at seven days before due date, on the due date and weekly thereafter. DSO fell to 52 days within four months, receivables to $10,400,000, and $3,800,000 of cash came back, saving about $228,000 a year in interest at 6%.
The price increase was not needed. The finance director's note to the board was that the customers had never been the problem; the company had been lending them money by being slow to ask for it.
Watch out
Common mistakes.
- Including cash sales in the denominator, which understates DSO, or netting the bad debt provision off receivables, which flatters it.
- Reading DSO without the ageing report, so that a few very old disputed balances are treated as a general collections problem, or a general problem is hidden behind an acceptable average.
- Blaming customers for a high DSO when the largest causes are usually internal: slow invoicing, unresolved disputes and inconsistent chasing.
Questions
People also ask.
What is a good DSO?
One close to the payment terms offered. On 30-day terms, a DSO in the mid-30s reflects the natural spread of sales within the month; above 45 suggests late payment or process problems. Sector norms vary, and comparison with the company's own terms is the most useful test.
How does DSO relate to the cash conversion cycle?
The cycle is inventory days plus DSO minus payable days. It measures the number of days between paying suppliers and collecting from customers, during which the business must fund its operations from its own cash or borrowings.
Can DSO be reduced without upsetting customers?
Usually. Invoicing on the day of delivery, resolving disputes quickly, making payment easy and reminding politely before the due date all reduce DSO while improving the customer's experience. Tightening terms or refusing credit are the last resort, not the first.
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