Days of sales outstanding (DSO) is a ratio that measures the number of days it takes for a company to collect cash from its credit sales. It is also used as an important liquidity measurement because the lower it is, the higher the liquidity of a business.
The formula for days of sales outstanding is expressed as follows:
An alternative approach:
The DSO ratio is usually calculated annually or quarterly and less often on a monthly basis. The value of trade accounts receivable is taken from the balance sheet. Because a balance sheet has the value of accounts receivable both at the beginning and at the end of an accounting period, the average value should be calculated.
The value of sales can be found in the income statement, but accounting standards do not oblige companies to disclose credit sales separately. Thus, the value of credit sales can be found either in notes to the financial statements or have to be provided by the company.
For calculating the days of sales outstanding, the actual number of days in the accounting period is commonly used, for instance, 365 days on an annual basis. In financial calculation, sometimes the 360-day year consisting of 4 quarters of 90 days each or 12 months of 30 days each can be used.
The balance sheet of a XYZ company is as follows:
US$ in thousands
The reported income statement for the current year is as follows:
Let’s assume that the number of days of sales outstanding in the prior year was 61, which means less efficiency in credit sales collection during the current year.
Days of sales outstanding analysis
A lower DSO ratio is desired. A decrease in the number of days of sales outstanding indicates an increase of a business’s liquidity. Companies should usually attempt to reduce the DSO ratio to increase their cash flow, but a strict credit policy can alienate customers and result in a drop in sales.
A higher number of days of sales outstanding can indicate the following:
- the company has a great proportion of credit sales
- a reduction in credit sales collection efficiency
- a review of credit policy is needed regarding mitigation
Regardless, a higher number is a first sign of a reduction in liquidity.
Other important key points of days of sales outstanding analysis include scale of business, industry average comparison, and trend analysis.
Generally, the larger the company, the higher DSO ratio will be healthy for it. For example, a value of 60 days is quite comfortable for a large, well-established corporation. At the same time, a value of 40 days can be hazardous for a small or new business.
The value of days of sales outstanding ratio can also vary depending on the type of industry. Thus, an industry average comparison is also an important part of analysis. Let’s consider the example above and assume the industry average in the current year is 59.3.
The current DSO ratio of 64 is higher than the industry baseline of 59.3, so the company is ineffective in collecting outstanding receivables.
An important issue of analysis is tracking the DSO ratio over time to determine whether or not it moves in a particular direction or has some specific patterns that may be caused, for example, by seasonality of sales. In other words, trend analysis is a very important issue.
You can also calculate the days of sales outstanding using our online calculator.