Days sales outstanding, also known as average collection period, measures the number of days it takes for a company to collect its accounts receivable from its clients. The collection of receivables is commonly carried out by the billing department and this metric is a particularly important one to determine that department’s efficiency. On the other hand, it also indicates the quality of the business’ clients in terms of their punctuality to fulfill the financial commitments they have with the company.
What is Days Sales Outstanding?
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This metric is an essential variable of the cash cycle estimation, which tracks the number of days it takes for a company to convert a sale into cash. A high number of days of sales outstanding will increase the length of the cash cycle, which can create severe cash flow issues or unnecessary financial costs for the business. On the other hand, the assessment of whether the metric is high or not has to take into account the average credit period extended to clients.
Management teams employ this metric to determine the healthiness of the client’s portfolio and also to identify potential causes for a cash flow issue. Companies that operate in industries where products are high-ticket, as is the case for machinery and vehicle producers, may pay special attention to this metric to make sure their cash flow remains steady over time, as they extend big credit lines to their clients in order to finance the large amounts associated to their purchases. Any delay on these payments may be significantly harmful for these businesses.
Days Sales Outstanding Formula
The days of sales outstanding can be calculated through the following formula:
Days of Sales Outstanding (DSO) = (Avg. Accounts Receivable / Net Credit Sales) * Number of Days
Days Sales Outstanding Equation Components
Avg. Account Receivables: The sum of total accounts receivable at the beginning of the period and the amount of receivables at the end of such period divided by 2.
Net Credit Sales: The total sales made to clients through commercial credit minus any discount, markdowns and any other item that may reduce the final value of the sale.
Number of Days: The number of days that have passed since the beginning of the period being evaluated and the end of the period. If it is a calendar year, the number of days would be 365.
The result of the Days of Sales Outstanding calculation gives a certain number of days, which is the number of days it takes on average for the business to collect its receivables.
Days Sales Example
Ocean Lamps is a company that designs and manufacture designer-style lamps for buildings and office spaces. The company has a client portfolio that is mostly comprised by construction companies and design companies. These clients buy big volumes from Ocean and they enjoy credit periods from 15 to 60 days depending on the size of the purchase.
Recently, the Finance Manager of Ocean has noticed that cash flow has been tight and he even had to apply for a loan to finance some expenses. He decided to look into the matter and in order to estimate the business’ days of sales outstanding he found this information:
The business started the year with $7,600,000 million in account receivables and after 95 days the accounts receivables were $9,600,000. Net credit sales year-to-date were $24,300,000.
With this information, he calculated the metric as follows:
Days of Sales Outstanding = [(($7,600,000 + $9,600,000)/2) / $24,300,000] * 365 = 129 days
It appears the business main clients, who owed 60% of the debt, were going through financial issues and they were late on their payments. This delay has caused cash problems to Ocean Lamps, who are experiencing more than twice the maximum credit period to collect the money owed.
Days Sales Outstanding Ratio Analysis
The Days of Sales Outstanding metric is essential to keep track of the company’s financial health, especially if they rely heavily on credit sales. Companies with government contracts, wholesalers, manufacturers and service providers such as law firms and accounting firms, they are all very susceptible to delays in the payments received from clients.
It is the Finance Manager job to keep track of the evolution of accounts receivable throughout time, to make sure that any peak on the number of days of sales outstanding is properly taken care of. A number of days that is higher to the maximum credit period extended by the company should be a warning signal that clients are taking longer than they should in paying for their invoices.
On the other hand, companies who sales are highly dependent on a handful of big clients may face severe financial issues if those clients start to miss their payment’s due dates, even though other clients may be paying on time.
In turn, a company with a low number of days of sales outstanding may be extending very short credit periods, which could be detrimental to the performance of its sales, as competitors can just offer longer periods to steal clients away. Nevertheless, it could also be an indication that clients are taking early payment discounts offered by the business.
Days Sales Outstanding Uses, Cautions, Pitfalls
One of the main things to keep in mind when analyzing the days of sales outstanding is the importance of comparing the result with the credit periods extended by the company. Acceptable days of sales outstanding from one company may not be acceptable for the other, when this comparison is taken into account.
On the other hand, a company may have been improving its collection process and that may not be immediately reflected on this metric if the time period evaluated is too long, given that the accounts receivable in the beginning of the period will be much higher and will distort the average.
Also, companies with declining sales may see an increase in the days of sales outstanding metric, even though collections are normal, because of the exact same reason described above.
Other metrics must be incorporated into the analysis to make sure that the big picture of the financial situation can be seen.