August 15, 2020

Metric Deep Dive: Days Sales Outstanding

What is Days Sales Outstanding?

Days Sales Outstanding (DSO) measures how many days on average it takes for a sale to convert to cash. In other words, it’s how long it takes for your customers to pay you.

DSO is a metric used to measure the efficiency of your finance team and its collections process.

Why is Days Sales Outstanding Important?

As much as closing sales is vital for a company’s survival, being able to convert those sales into cash is just as important.

Cash is king! Receiving payments from your product or service will allow your company to pay off operational expenses, invest back into itself, and scale.

Imagine you have a high volume of sales one month, but half of those sales are late on paying their invoices. If you’ve paid off expenses and invested into your company believing you would receive 100% of the cash, you would be in big trouble. What if some of those sales never end up paying? Even bigger trouble.

DSO not only measures how quickly (or not so quickly) your account receivables will be paid off, but also how much liquidity and cash you will have on hand.

Investors love DSO exactly for this reason. Sure, they are interested in your ARR and growth in sales, but what they really care about is how quickly sales are converted into cash - and then into their wallet.

How to Calculate Days Sales Outstanding

DSO calculations can vary depending on payment terms. If you use monthly payment terms, here’s what we recommend:

Formula: DSO = [(month-end AR balance) ÷ (monthly revenue X 12)] X 365

DSO+-+example+1.jpg

On average, it takes Firm X’s customers 28.63 days to pay their invoices.

Days Sales Outstanding Benchmarks

A low DSO means it takes a company fewer days to collect its account receivables. This results in high liquidity and high cash flow.

A high DSO, on the other hand, means it takes a company more time to collect its account receivables; This may lead to cash flow problems if not properly planned for in the long term.

Whether your DSO is high or low is relative to your payment term. If your payment term lasts 45 days and your DSO is an average of 35 days - congratulations! You not only have a low DSO, but also an efficient collections process, as your customers are paying you before their invoice due dates.

However, if your DSO is 35 days with a payment term of 30 days - it might be time to take a deeper look in your business. If your customers are consistently missing payment due dates, explore adding into your contracts late payment penalties and interest in order to incentivize them to pay on time and mitigate the downside delayed collection.

DSO benchmarks will vary industry by industry - some have a median DSO of 30 days and others have 90 days.

Shopify, a B2C SaaS company, has a DSO of approximately 20 days. On the other hand, Microsoft, mainly a B2B SaaS company, has a DSO of approximately 77 days. Product, customers, and niche industries can impact what makes a DSO acceptable or not.

Compare yourself against competitors within your industry. This is a great way to assess your collections process.

Overall, keeping your DSO as low as possible is the best way to go.

How to Improve Days Sales Outstanding

Keeping your DSO low means sales are converting to cash a lot quicker. With that cash on hand, your company has the opportunity to pay off expenses and invest in itself. Lowering DSO = optimizing cash flow.

With that in mind, before prescribing remedies for your high DSO, it’s important to understand why payments are getting delayed by getting to the root of the problem.

Reasons for Payment Delays & Solutions

1) Customers don’t have the cash on hand to pay invoices

When payments are delayed because customers are having their own cash flow issues, it is not a major concern until a high volume of customers start doing it repeatedly. If you find your company has too many customers with cash flow problems, it might be time to talk with your sales reps and start focusing on more cash flow positive leads.

2) Dispute over product/service quality

A customer could dispute product/service quality and hold off on paying the invoice since the service was not up to par. As you are resolving these issues, collect money from the other components of the invoice that are not in dispute. This way, you are not losing time or money on all of the invoice, only the component that is being disputed.

3.) Missing/incomplete invoices or paperwork

One major reason for a high DSO is a company’s ineffective invoice management system. Missing invoices or incomplete paperwork are issues that can easily be avoided through automation. Automating your collections process will decrease human error and lower DSO.

Another way to improve your DSO is through incentivizing early payments (if you are in a cash crunch) and punishing late ones. Offering discounts to customers who pay before the payment term limit and implementing late payment fees can help lower DSO.

Tip

Keep your payments organized - your accounting or payment processing system should be able to spit out a report that tracks payments received, late ones, failed transactions, etc. This way you can keep track of your cash flow and follow up on late payments.

What Days Sales Outstanding does NOT tell you

While DSO is a great metric to measure the effectiveness of your collections process and keep track of your cash flow, it is not the be-all end-all indicator of your company’s performance or liquidity.

DSO does NOT measure cash sales - only credit sales. When using DSO to track how quickly your credit sales are converting to cash, don’t forget the cash flow that may be coming from cash sales.

DSO is NOT an accurate accounts receivable efficiency metric. Since sales volumes can vary time from time, any sudden changes in sales can lower or raise DSO. Remember, DSO can be impacted by confounding factors and your finance team’s effectiveness may not always be the answer.

Just like any SaaS metric, DSO should not be used alone, but with other metrics to get a better picture of the company’s overall health.

Days Sales Outstanding During Downturns

Whether it's an economic downturn or seasonal downturn, your DSO may be higher than usual as a result.

Seasonal Downturns

Your product or service may face off seasons in sales; this is not something to worry about. Seasonality is acceptable as long as DSO is not higher than usual compared to trends from years prior.

Economic Downturns

During economic downturns - more of your customers may face cash runway problems. Expect a higher DSO. Keep in mind:

  • Compromise and leniency is key. Being too strict may cause a customer to churn.
  • Write off a customer’s late payment one month. This may be a great customer service trick (just make sure this act of kindness won’t ruin your business!)
  • Maintain your customer relationships. At the end of the day, they are the ones that provide your company with money, regardless of how early or late the money gets to you.
“Assume you are going to get paid slower than you were getting paid pre-crisis. This will help you avoid assuming you have more runway than you do.”

— William Cordes, Founder KPI Sense

For more tips on how to survive and thrive during downturns, find out what our founder has to say about DSO and other metrics.

TL;DR

Days Sales Outstanding measures how many days on average it takes for a company to to collect its account receivables in a given time period. The faster your invoices are paid, the faster sales are converted into cash available to invest back into your business. DSO is a great way to track your cash flow and measure the effectiveness of your finance team and their collections process. Investors also love fast cash conversions, so scroll back up to learn how to reduce your DSO.

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