BUS202: Principles of Finance

Days sales outstanding (also called DSO or days receivables) is a calculation used by a company to estimate their average collection period.

TERMS

• average collection period

  365 divided by the receivables turnover ratio

• outstanding check

  a check that has been written but has not yet been deposited in the receiver's bank account

• business cycle

  The term business cycle (or economic cycle) refers to economy-wide fluctuations in production or economic activity over several months or years.

• days in inventory

  the average value of inventory divided by the average cost of goods sold per day

Days Sales Outstanding

In accountancy, days sales outstanding (also called DSO or days receivables) is a calculation used by a company to estimate their average collection period. It is a financial ratio that illustrates how well a company's accounts receivables are being managed. The days sales outstanding figure is an index of the relationship between outstanding receivables and credit account sales achieved over a given period.

Typically, days sales outstanding is calculated monthly. The days sales outstanding analysis provides general information about the number of days on average that customers take to pay invoices. Generally speaking, though, higher DSO ratio can indicate a customer base with credit problems and/or a company that is deficient in its collections activity. A low ratio may indicate the firm's credit policy is too rigorous, which may be hampering sales.

Days sales outstanding is considered an important tool in measuring liquidity. Days sales outstanding tends to increase as a company becomes less risk averse. Higher days sales outstanding can also be an indication of inadequate analysis of applicants for open account credit terms. An increase in DSO can result in cash flow problems, and may result in a decision to increase the creditor company's bad debt reserve.

A DSO ratio can be expressed as:

• DSO ratio = accounts receivable / average sales per day, or
• DSO ratio = accounts receivable / (annual sales / 365 days)

For purposes of this ratio, a year is considered to have 365 days.

Days sales outstanding can vary from month to month and over the course of a year with a company's seasonal business cycle. Of interest, when analyzing the performance of a company, is the trend in DSO. If DSO is getting longer, customers are taking longer to pay their bills, which may be a warning that customers are dissatisfied with the company's product or service, or that sales are being made to customers that are less credit worthy or that sales people have to offer longer payment terms in order to generate sales. Many financial reports will state Receivables Turnover defined as Net Credit Account Sales / Trade Receivables; divide this value into the time period in days to get DSO.

However, days sales outstanding is not the most accurate indication of the efficiency of accounts receivable department. Changes in sales volume influence the outcome of the days sales outstanding calculation. For example, even if the overdue balance stays the same, an increase of sales can result in a lower DSO. A better way to measure the performance of credit and collection function is by looking at the total overdue balance in proportion of the total accounts receivable balance (total AR = Current + Overdue), which is sometimes calculated using the days' delinquent sales outstanding (DDSO) formula.