DSO: what is it, and how does it improve cash flow?

In today's economic climate, marked by major uncertainty, managing cash flow is more important than ever. That's why understanding metrics like DSO plays a key role in a company's success. At the same time, effective cash flow management gives companies more control over their business and financial health.

That's why you should pay close attention to the DSO (Days Sales Outstanding) metric, especially if you often sell products or provide services on payment terms. Among other things, DSO shows whether you have the cash you need to pay debts, invest, or protect your business during difficult economic periods.

What is DSO?

DSO is a lesser-known financial metric that measures how long it takes to collect receivables, in other words, how long it takes a company to get paid after invoicing.

How is DSO calculated?

Days Sales Outstanding is calculated as follows:

DSO = (value of receivables on payment terms / total sales) x number of days

How should DSO be interpreted?

DSO should be interpreted carefully, because its meaning depends on several factors.

If your DSO is high, it may point to poor invoice management or difficult payment terms that make it hard for customers to pay on time. That's why you should look at:

• your payment-term policies;
• the types of customers you offer this payment option to.

A rising DSO shows that more cash is tied up in outstanding receivables, which may signal an approaching cash crunch.

A high DSO can also reflect changing market conditions. It may even point to efficient management of sales on payment terms, if your business can afford to offer customers longer payment terms.

On the other hand, a low DSO suggests that your company takes a reasonable amount of time to collect money from customers.

So businesses should keep their receivables at the lowest possible level. To better understand receivables, you need to determine how long it takes to collect an outstanding receivable.

What are outstanding receivables?

Outstanding receivables are amounts a customer owes a company for products sold or services provided, with payment due on the agreed due date. Since receivables are eventually turned into cash, they are a short-term asset on the balance sheet.

What is the role of DSO?

This metric helps you understand the average number of days needed to collect issued invoices. DSO also reflects:

• customer satisfaction and creditworthiness;
• the effectiveness of the employees responsible for collecting payments from customers, which can affect your business's profitability.

Evaluating DSO also helps you identify issues in the receivables collection process, estimate cash flow, and spot cash flow trends.

DSO is just one of the key indicators when you analyze business performance. To fully understand the state of your business, you also need to pay attention to your financial reports, as well as other KPIs.

What challenges come with calculating DSO?

DSO gives you an overall picture of a business's financial health. Still, there are several reasons why this metric may not fully reflect efficiency and profitability. The most important factors include:

• Seasonality can skew DSO because it is a linear metric and may show similar patterns over a given period. In seasonal industries, you should compare the months or quarters of the previous year with those of the current year. That helps you manage drops and spikes in cash flow.
• Sales complexity matters because the complexity of your offers, the types of promotions you run, and extended payment terms all affect gross revenue. However, complex payment terms or a large number of customers with low creditworthiness brought in by a promotion can distort the real picture of what is happening in your business.

Even so, you can overcome these challenges with adjustment calculations. That's why DSO remains an important metric in financial analysis.

How can DSO be improved?

To lower your DSO, there are a few strategies worth considering:

1. Automate customer reminders Use automated tools to remind customers when it's time to pay invoices for products sold or services provided. You can also give them an overview of all current and past invoices, so they can see the amount due and the due date. This saves you time and helps you maintain customer relationships by avoiding collection calls that could create conflict.
2. Implement digital payment solutions By offering customers the option to pay online, you no longer have to wait for checks to arrive, which eliminates the problem of cash being tied up in receivables.
3. Use customer-friendly receivables collection solutions Through factoring, companies can collect issued invoices on time without depending on customers. This allows businesses to pay their own debts (for example, to suppliers), improving DSO. They no longer have to pressure customers to pay faster. Instead, customers can pay on a much later date.