Days Sales Outstanding is an important component of the Cash Conversion Cycle (CCC) in a business. This metric is crucial to understanding the cash flow problems and supply chain process. CCC helps identify the issues with the efficiency of the management and sales team in delivering products from inventory to customers and receiving cash in return.
For this, you need to understand the Days Sales Outstanding completely. So that, you can point out the company’s liquidity and inefficiency in the payable receivables and sales process. So, let’s discuss what days sales outstanding is. Also, we will explain how to calculate DSO and what is the importance of this CCC component? Before this, we will introduce Cash Conversion Cycle and its different types. So, let’s delve deep into this important estimation!
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What is Cash Conversion Cycle (CCC) and What are its Components?
The Cash Conversion Cycle is an estimation of how much liquid is your company from inventories to sales. For example, it explains the number of days required to finance your inventories and get receivables after the sales of the products.
A higher CCC Value means your cash flow system is inefficient and there are problems with the sales team. It means to say your company is selling products on credit and financing the inventories by borrowing money. So, a lower value of CCC means your cash flow process is speedy and you are receiving cash immediately to finance your products and working capital. Moreover, your company is receiving payments from the customers instantly.
The Cash Conversion Cycle comprises the three main components.
- Days Inventory Outstanding (DIO)
- Days Sales Outstanding (DSO)
- Days Payable Outstanding (DPO)
The formula for calculating the Cash Conversion Cycle (CCC) is:
CCC = DIO + DSO + DPO
We will discuss only Days Sales Outstanding (DSO) in this article. So, let’s start!
What is Days Sales Outstanding (DSO)?
After calculating the number of days a company holds its inventories in the Days Inventory Outstanding (DIO), the next step in the CCC calculation is to estimate the Days Sales Outstanding (DSO).
DSO measures the average number of days for receiving the payments from the customers and clients who have purchased the products or services of a company. The number of days can be calculated daily, weekly, monthly, quarterly, or annually.
If a company receives the payment from clients in more days, it means the company is selling products on credits. This is the reason, a company can have challenges in the cash flow and smooth financing of working capital. As a result, cash flow problems can hinder the progress and growth of a company.
Therefore, an organisation must try to reduce the number of days to turn accounts receivables into cash. The more quickly a company converts its receivables, the higher its liquidity of a company. Greater liquidity and cash existence are good indicators of the health of a business.
What is the Formula for Calculating Days Sales Outstanding?
The formula for calculating the DSO is simple and requires only two numbers accounts receivables and net credit sales. Moreover, you need a number of days for which you want to analyse the DSO.
Days Sales Outstanding = (Accounts Receivables/ Net Credit Sales) * Number of Days
Accounts Receivable is the due payments by the clients who have received or used the products or services.
Net Credit Sales are calculated as
Net Credit Sales = Sales on Credit – Sales Return – Sales Allowance
Sales Return refers to a credit that has been issued to a customer for a delay in shipment and poor service.
Sales Allowance refers to a lower price than the actual price due to poor product quality, short shipment, and price or order problems.
Example
For example, there is a company A with the following accounting information. The manager of the company wants to calculate DSO for the month of May 2021.
|
Sales Revenue |
Credit Sales |
Cash Receivables |
|
£2 million |
£1 million |
£ 500 000 |
Days Sales Outstanding = (Accounts Receivables/ Net Credit Sales) * Number of Days
Days Sales Outstanding = (£ 500 000/£ 1 000 000 )*30
Days Sales Outstanding = 15 days
It means the company receives its due payments in fifteen days on average. Typically, a number lower than 45 DSO is considered a good indicator of a company’s cash flow.
A Higher or Lower DSO? Which One is Better?
A higher value of DSO reflects the business is getting its receivables in more days. However, this number varies from business to business and industry to industry. Therefore, you can compare the DSO of your company with other companies in the industry to analyse the efficiency of your company.
On the other hand, a lower DSO indicates the healthy financial position of your company. In other words, your receivables are in cash or you are selling products to customers with a good credit rating. However, you can improve your DSO estimation by reducing the sales on credit or lowering the number of clients with poor credit ratings.
Why is Days Sales Outstanding is Important?
Measuring DSO is important in business as it helps in the calculation of Cash Conversion Cycle. In other words, you can analyse the cash flow and liquidity position of your company’s current assets. Cash is at the centre of managing your daily expenses and you can pay your invoices to the supplier. Moreover, working capital operations also require cash every day.
So, a business must plan to receive customer receivables and credit as quickly as possible. A lower DSO will help grow your business by managing the cash problems instantly and running the business operations smoothly.
Final Thoughts
Lastly, calculating Days Sales Outstanding can provide you with a figure, reflecting where your cash flow stands. A hurdle in the cash flow or liquidity of your inventories or sales can hamper the growth of your company. So, it’s crucial to achieve a lower DSO in the Cash Conversion Cycle (CCC).
Once you calculate Days Sales Outstanding, you can calculate Days Payable Outstanding (DPO) in the CCC process. DPOs refer to the due payments by the company to the suppliers or lenders. So, you can add all these DIO, DSO, and DPO to calculate Cash Conversion Cycle (CCC) and analyse how liquid your current assets are.
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Disclaimer: This article provides general commentary on, and analysis of, the subject addressed. We strongly advise that you consult an attorney or tax professional to receive legal or tax guidance tailored to your specific circumstances.