Working Capital DSO - A Key to Unlocking Cash Flow

As a business owner, tracking your company’s financial metrics is important. Working capital is one of the most important things to pay attention to because it is a measure of the amount of cash your company has to pay for its current needs. 

Days Sales Outstanding (DSO) refers to how long it takes to collect money from the sale of goods or services, your company’s DSO plays a big role in your business’s working capital, so tracking and improving your DSO will help you boost your working capital.

Understanding Working Capital Days Sales Outstanding (DSO)

Given its importance to your company, it’s key to understand working capital and days sales outstanding.

What Is Days Sales Outstanding (DSO)?

Days sales outstanding (DSO) is a measure of how long it takes for your company to collect money after selling goods or services. Many businesses, when they sell a product or service, will send an invoice to the purchaser. It can then take days or weeks for the buyer to submit payment.

DSO is the number of days it takes to get paid after you send an invoice. The lower your company’s DSO, the less time you have to wait between making a sale and getting paid.

DSO is a working capital ratio because the amount of time it takes to get paid influences your business’s working capital.

What Is the DSO Formula?

The formula for DSO is:

(Average accounts receivable / revenue) * 365 = DSO

How Do You Calculate DSO?

To calculate DSO, you need to know two things.

First, you need to know your business’s average accounts receivable over a period, often a year. You can usually find this information in bookkeeping or accounting software. You also need to find your revenue for that same period.

Divide your average accounts receivable by revenue and you’ll get a result that is typically less than 1.0. Multiply that answer by the number of days in the period to find your answer.

Example of the DSO Calculation

Imagine that you run a business with $150,000 in annual revenue and average receivables of $11,000. The company’s DSO would be:

($11,000 / $150,000) * 365 = 26.77

This indicates that it takes roughly 26 to 27 days from the time your company makes a sale to the time it gets paid for that sale.

How Is DSO Used?

DSO is useful because it is a powerful tool for forecasting income. Companies are constantly dealing with cash inflows and outflows and rely on revenue to pay the bills.

A company with a high DSO knows that it needs to make sales sooner rather than later if it has a bill coming due in a few weeks. Companies with low DSO have more flexibility regarding the timing of their sales and are less likely to face working capital issues.

Why Is Working Capital DSO Important?

Working capital measures the amount of cash that a business has on-hand to pay short-term obligations. DSO determines how quickly each sale increases a company’s working capital. The lower a business’s DSO, the faster each sale turns into cash that can be used to pay the bills.

If your business has a very high DSO, you’re more likely to face cashflow problems even if you have healthy sales overall.

High vs Low DSO Working Capital Ratio

When you make a sale, you’d rather get paid sooner than later. That’s why it’s important to understand what qualifies as a high DSO vs a low DSO.

What Is a High DSO?

The issue with determining what counts as a high or low DSO is that it can vary significantly based on a variety of factors.

In general, it’s best to compare yourself to competitors in your industry and to compare your DSO to the stated terms on your invoices. For example, if your invoices state that you expect full payment within 60 days of submitting the invoice and your DSO is much higher than 60, that’s likely to be a problem.

What Is a Low DSO?

In general, the lower your DSO, the better it is for your business. In many industries, DSO under 45 is considered low. However, this depends on your industry and other factors.

Factors that Affect DSO

There are many different factors that can influence your company’s DSO, including:

• Payment terms. The terms you include in your invoices play a key role. Shortening the time to pay or adding early payment discounts can lower DSO.
• Revenue fluctuations. Changes in your company’s revenue can impact your DSO calculations. For example, if your revenue rises, it can boost receivables and DSO if your collections staff can’t keep up.
• Your industry. Each industry has different standards for how long companies take to pay invoices.
• Invoicing accuracy. Mistakes on invoices can slow down payment and raise DSO.

DSO Interpretation by Industry

The industry you operate in has a huge impact on your company’s DSO and what qualifies as a high or low DSO. Many industries expect DSO to be 60 days, 45 days, or less, but some industries have much higher DSOs.

For example, oil and gas extraction companies have an average DSO of more than 110. On the other hand e-commerce businesses may have DSO as low as 7 days.

Factors such as the size of invoices, competitiveness of the industry, and standard methods of payment can all play a role in the differences between industries. 

What Are the Indications of High or Low DSO?

To determine whether your company has a high DSO or a low DSO, compare your DSO to both the terms of your invoices and the DSO trends in your industry.

If you’re generally getting paid on-time, well ahead of your invoicing terms, you likely have a low DSO. If your DSO is significantly higher, 25% or more, than your invoice terms, you have a high DSO.

The Impact of DSO on Cash Flow

The reason DSO is so important is that it plays a big role in cash flow.

To sell goods and services, you usually need to buy raw materials and supplies, which means cash outflow. If it takes a long time to turn sales into a cash inflow, you could have cash flow problems where you don’t have the working capital to pay your bills, even if your accounts receivable would be sufficient to pay what you owe.

That’s why high DSO is such a major issue. The longer it takes to turn sales into cash flow, the more likely your business is to face problems with working capital.

Benefits and Limitations of the DSO Working Capital Ratio

DSO working capital is a useful metric, but they do have shortcomings to consider.

Benefits of DSO 

• Track and improve collections. Tracking DSO lets you know how long it takes to get paid and whether that timeline changes. You can target certain levels of improvement or respond to worsening DSO.
• Forecasting. Knowing your DSO can help you estimate your working capital on any given future day based on outstanding invoices.
• Customer satisfaction. Low DSO can correlate with customer satisfaction while high DSO can indicate customers who don’t want to pay bills for poor products or work. Tracking DSO can help track satisfaction.

Limitations of DSO 

• Limited use across industries. DSO varies a lot from one industry to another, so you can’t compare yourself to other companies using it.
• Revenue plays a role. Larger companies tend to have higher DSOs, so DSO isn’t great for comparing small companies to larger ones.
• It’s an average. DSO tracks averages for all receivables. It won’t help you identify, for example, one company that takes twice as long to pay as other customers.

Common Challenges in Managing Working Capital and DSO

Business owners looking to manage their working capital and DSO face many challenges, including:

• Forecasting cashflow. Knowing how much cash you’ll have on hand is key for business owners. DSO is one tool to use to improve your ability to forecast but is just one piece of the puzzle.
• Balancing credit sales and timely payment. Extending credit can help you convince customers to make larger purchases but that comes at the cost of lower DSO. You can combat this by offering discounts for early payments.
• Inefficient invoicing and collections. Error-ridden manual processes can worsen your DSO. Automating invoicing and collections where possible to reduce mistakes and lower DSO.
• Inventory management. Managing your inventory is also important for cash flow. Too much inventory means wasting working capital on unneeded inventory while insufficient inventory means missing out on sales.

How to Reduce Days Sales Outstanding (DSO)

There are a few ways you can lower your company’s DSO.

• Shorten payment terms. If you currently give customers 60 days to submit payment, try shortening the timeline to 50 or 45 days. However, recall that this could annoy customers and reduce sales.
• Offer early payment discounts. Consider offering a small discount to customers that pay invoices within a few weeks. This can improve DSO at the cost of slightly lower revenue.
• Invoice quickly. The sooner you invoice, the sooner you’ll get paid for your sales.
• Better collections practices. Have your staff reach out to your customers to encourage payment of unpaid invoices sooner rather than later.
• Check customers’ credit. Before extending credit to a customer, do some due diligence to ensure they won’t leave the invoice unpaid.

DSO vs DPO: How Are They Different?

Another metric that is similar to DSO is Days Payable Outstanding (DPO). DPO is the reverse of DSO, measuring how long it takes your business to pay its bills. The longer your DPO, the slower you are to pay invoices.

Having a low DPO makes you a more appealing customer to other businesses, but a high DPO means you keep cash on hand for longer and will have fewer cash flow problems. Try to strike a balance between these two sides of the equation.

Final Word

DSO is a key metric for business owners to track. The lower your DSO, the better it is for your company’s working capital and cash flow. By tracking this metric, you can monitor for unexpected changes and take steps to improve it. 

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