Days Sales Outstanding basically refer to the average number of days that the entity takes to collect its credit sales over the period of time.
The company measures this ratio in order to manage the efficiency and effectiveness of credit policy as well as receivable collection procedure.
If the ratio is high that means that the company spends more days to collect credit or accounts receivable. In contrast, the low ratio means the company credit policy or collection procedure works very well.
Days Sales Outstanding could be measure depending on the management intention for example monthly, quarterly, and annually.
However, in most cases, the period that management measure is monthly. This is because such measurement could let management review the trend from month to month.
(Accounts Receivable/ Total Credit Sales) Number of Days
- Accounts Receivable: Accounts receivable balance at the end of the period that we want to calculate the ratio. However, averages of accounts receivable are mostly used to eliminate the bias as the result of carrying forward of accounts receivable from last previous period.
- Total Credit Sales: This is the total of credit sales during the period. It can be monthly, quarterly, and annually. In most cases, the calculation is monthly.
- Number of Dates: This is the number of days that we want to calculate, say, 30 days, or 90 days.
Now, let move to the example so that we can clearly understand.
Assume a company had its credit sales amount SUD 600,000 during the month of December 2016 and the average of accounts receivable during December was USD 60,000. What is the DSO of the company for the month of December?
Now we know the company’s total credit sales which are USD 600,000, averages of AR which is SUD 60,000. This lead to AR/credit sales is 0.1
Therefore, DSO of the company is 0.1 X 31 = 3.1 days.
The answer proves that the company spends an average of 3.1 days to collect convert its credit sales into cash. Once off calculation could not really help management to analyze whether current collection performance or credit policy work well or not.
The best practice to do this is to review the trend over a period of time. Let say, monthly DSO over twelve months.
A company has its accounts receivable at the end of the first quarter amount USD 700,000 and total credit sales for the first quarter are USD8,000,000.
In this case, number of days per quarter is equivalence to 30 X 3 = 90
Then the calculation would be,
(700,000/8,000,000) X 90 = 7.87 Days
The DSO for this company, based on the calculation above, is 7.87 days
Noted: Even in this example, we use quarterly data to calculate, DSO still measure in days. This also applies for yearly calculations.
A company’s total accounts receivable for the year is above USD 1,000,000 and its total credit sales for the year is USD 10,000,0000. Management wants to assess the DSO and review the collection procedure annually.
Based on information above,
(1,000,000 / 10,000,000) X 365 = 36.5 days.
Why do we need to measure Days Sales Outstanding?
Managing the company cash flow, and working capital is very important for the management of the company. Days Sales Outstanding could help management to assess whether the company’s current credit policy and collection are working well if compared to the previous period, competitor, or industry averages.
Advantages of DSO:
- Predict cash flow
- Monitor cash collection procedure
- Monitor credit policy
- Monitor accounts receivable closely
Disadvantages of DSO:
- Cannot use to compare with others company with different industry
- It is not the best tool to measure the efficiency of accounts receivable collection.
- Not very useful if we use it alone or one-off