Knowing how quickly sales invoices turn into cash is an important information for the management of any business.
The basis of good accounts receivable management is the ability to know how long, on average, customers are taking to pay the business. Having this information in hand allows management to gauge their performance and make any necessary changes to credit policy. A simple formula for calculating days sales outstanding (DSO) is to take the closing balance of accounts receivable in a given period and divide it by the total accounts receivable turnover for the same period. By multiplying the resulting figure by the number of days in this period, the average number of days is revealed. (Closing accounts receivable/total accounts receivable turnover) x days in the period.
Closing accounts receivable = £150,000
Total accounts receivable turnover = £300,000
Number of days in period = 90 (£150,000/£300000) x 90 = 45 days
Making use of the figures
It is all well and good being able to calculate these figures. However, good credit management requires some further analysis, especially if the resulting number is a long way off the standard credit terms offered to customers. In the example above, an average of 45 days is considered not too bad even if the standard terms are 30 days. A little extra effort in the collection process might lower the number slightly. If however, credit terms are 30 days and the DSO came out at 60 days, there is an issue which needs addressing.
Outside looking in
For anybody looking at a company’s DSO as an outsider this formula, whilst still valuable, needs to be looked at in the light of other facts. In addition to comparing DSO to standard credit terms offered, it is useful to compare it to the industry standard. Industry type can have a significant bearing on DSO and anything affected by seasonality will show a varying position over a year. In this respect, it would be useful to not only calculate DSO figures for different periods of the year but to also work out the annual accounts receivable turnover. This figure shows how many times in the year accounts receivable turned over and is arrived at by dividing total annual sales turnover by the average accounts receivable balance throughout the year. All good credit advice will say the same thing. Final word The above formulas are good starting points but they are only averages. The fact that well performing debt could seriously be masking overdue accounts is an issue which only a thorough study of an aged receivables report will uncover.