The mere fact that any business has debtors implies that it is financing the ability of its customers to purchase from the business. This fact is balanced to the extent that the business itself obtains credit (funding) from its suppliers.
Many businesses will determine their terms of trade on the basis of what is generally acceptable in the industry, and importantly, what resources it has to fund those debtors, either out of its own cash resources or funding from its own suppliers in the supply chain. The ultimate trick perfected by many retailers is to sell for cash but squeeze extended credit terms from suppliers. Most businesses are somewhere in between, and close attention to your debtor days value is important when managing cash flow required for the business. Days Sales Outstanding (DSO) is another name for the same thing.
This is one of the most critical performance metrics in the debt collection process. It tells you the average number of days sales still outstanding based on the period of activity assessed. It is worth noting that DSO measures the efficiency of your collections in terms of how quickly the invoices are converted to cash rather than the effectiveness of your collections in terms of what activities result in the best client behaviour.
Have a look at this quick DSO calculator to see how reducing your DSO could release cash back into your own business.
A lower DSO is good and means clients pay their invoices in a timely manner, a higher DSO means clients pay slowly and quite probably late. A high DSO means the company is using its own cash to fund the business rather than funding from cash recovered from clients. When you go out to replenish product stock or pay salaries it is a far healthier position to be paying with money from sales rather than money from capital.
If the client DSO value is close to the client payment terms then they are behaving well, however if for example the terms are 30 days and the DSO is 60 days then you have some work to do. A low DSO can also be a health indicator of client satisfaction (happy clients pay their bills) and indeed in the quality of the business as a whole.
There are no right and wrong values for DSO however there are forums for most industries where membership will include access to common benchmarks, best in class, etc. As an example, for some industries if your payment terms are 30 days then a common and reasonably achievable goal is to keep DSO in the high 30s or very low 40s. Best in class would probably be consistently sub 35 days. The target really becomes an average, as many businesses have different types of transactions which attract differing terms, and of course different client categories may have varying terms.
One of the most valuable applications of the KPI is to analyse the DSO over time by various dimensions. You may want to see DSO trends broken out by account manager, and perhaps also by geography, client sector, client size, project or product. Measuring your collections staff by DSO can create a healthy competitive atmosphere where people strive to better each other in keeping the DSO down for their allocated accounts. When a collector only has time for one more phone call in the afternoon they should perhaps target it at a client that counts most, from a DSO perspective.
Some organisations use the value of a single days’ DSO as the target for sales/account managers to agitate their clients to settle outstanding dues. If each account manager succeeds in reducing your DSO by a day then you will have recovered a meaningful amount of cash back into the business at little cost of sale. For some organisations they discover that reducing their DSO by 10 days is worth more to the business than increasing sales by 10%.
Whilst the focus on the DSO is one of the most valuable in managing cash, celebration of an excellent DSO measure must not be allowed to breed complacency and the traditional techniques and activities in the collection management must be ongoing in order to maintain the clear focus.
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