4 Methods to Achieving an Accurate DSO Calculation
In finance, DSO (Days Sales Outstanding) is the average number of days it takes a company to collect its receivables. DSO is calculated by dividing the total amount of accounts receivable by the average daily sales for a given period and then multiply this number by the number of days in the period. A smaller DSO indicates that the company is collecting its receivables quickly and efficiently.
What is DSO and why does it matter?
A high DSO indicates that a business is collecting payments from its customers at a slower rate, which can negatively impact its cash flow and liquidity. A company with a low DSO is an indication that they effectively manage their cash flow and have efficient A/R procedures.
DSO is a critical metric for businesses to track, as it enables them to identify potential cash flow issues and implement corrective measures. It’s also useful for assessing trends over time and comparing a company's performance to industry benchmarks.
How do you determine the optimal DSO?
1. The Balance Sheet Method
The Balance Sheet Method utilizes the A/R balance as reported on the balance sheet and the total credit sales as noted on the income statement.
(Accounts Receivable / Total Credit Sales) x Days Sales Outstanding
Let's consider a quick example:
Say a company has an accounts receivable balance of $100,000 and $500,000 in total credit transactions over a 30-day period. To compute the DSO, follow these steps using the formula DSO = (Accounts Receivable / Total Credit Sales) x Number of Days:
Divide accounts receivable by credit sales total:
$100,000 / $500,000 = 0.2
The result is then multiplied by the number of days in the period, so 30 in this scenario:
0.2 x 30 = 6
As you can see, the 30-day DSO for the company is six days, meaning the company takes an average of six days to collect payment from its customers following a sale.
2. The Income Statement Method
The DSO can also be calculated by dividing the accounts receivable balance by the average daily sales. This method is known as the Income Statement Method as it calculates DSO based on the average daily sales reported on the income statement and the number of days in the period.
The formula used in this calculation is as follows:
DSO equals Accounts Receivable divided by (Total Credit Sales / Period Length in Days).
This method is advantageous when a company's credit sales fluctuate during the measurement period because it accounts for sales fluctuations.
If a business has $100,000 in A/R and $1,000,000 in credit sales over a period of 90 days, its daily sales average would be $11,111 ($1,000,000 divided by 90). Following is how the DSO would be computed:
DSO = $100,000 / $11,111 = 9 days
In this scenario, it takes the company an average of nine days to receive payment from customers following a sale.
3. The Average DSO Method
An additional significant method for calculating DSO utilizes the average accounts receivable balance as opposed to the closing balance. The method is referred to as the "Average DSO" technique, and it calculates DSO as follows:
DSO = (Average Accounts Receivable / Total Credit Sales) x Accounts Receivable Days
Add the beginning and ending balances and divide by two to determine the average accounts receivable balance for a period. (50,000 + 70,000) / 2 = $60,000
Using this method, if total credit sales for the period amounted to $500,000, the DSO would be: DSO = ($60,000 / $500,000) x 90 = 10.8 days.
This method is useful when a company's accounts receivable balance fluctuates substantially during the measurement period, as it smooths out these fluctuations and provides a more accurate picture of the DSO. Nevertheless, it may necessitate more frequent calculations and be more time-consuming than the other methods.
4. The Countback Method
Calculating DSO The Countback Method is a technique for estimating the number of days it takes a business to collect its accounts receivable by analyzing historical data. This method requires a monthly comparison of accounts receivable and sales on credit, followed by the addition of the number of days for each month.
DSO = (Accounts Receivable / Credit Sales Monthly) x Number of Days in the Month
To calculate the DSO for a given period, you must add the DSO for each month and divide by the total number of months in the period.
(DSO for Month 1 plus DSO for Month 2 plus... plus DSO for Month n) / n
Here is an illustration of how to employ the Countback Method:
Consider a business with $100,000 in accounts receivable and $500,000 in credit sales for January. The business had $80,000 in accounts receivable and $600,000 in credit sales in February. The business had $120,000 in accounts receivable and $700,00 in credit sales in March.
To calculate DSO using the Countback Method, we begin with the most recent month and count backward the number of days it takes to collect accounts receivable. For the month of March, accounts receivable are overdue by 51 days ($120,000 ÷ $700,000.00 x 31 days). The number of days in February is then counted backward. In this instance, it takes 38 days to collect February accounts receivable ($80,000 ÷ $600,000 x 31 days). Finally, we count back the number of days for the month of January. January accounts receivable are collected in 62 days ($100,000 ÷ $500,000 x 31 days).
To calculate the overall DSO for the quarter, we add up the individual days for each month and divide by the number of months in the quarter. In this case, the overall DSO for the quarter would be 50.3 days (51 days + 38 days + 62 days ÷ 3 months).
What’s the Best Way to Calculate Your Days Sales Outstanding (DSO)?
The best way to calculate your Days Sales Outstanding (DSO) depends on your specific needs and circumstances. Each of the methods we discussed - Balance Sheet Method, Income Statement Method, Average DSO Method, and Countback Method - has its advantages and disadvantages, and different organizations may find one method more suitable than the others.
For example, the Balance Sheet Method is the most widely used method, and it is relatively easy to calculate since it uses accounts receivable and total credit sales figures that are readily available from financial statements. However, it only provides a snapshot of DSO at a specific point in time and does not take into account fluctuations in accounts receivable balances over the period being measured.
On the other hand, the Income Statement Method and Average DSO Method provide a more accurate picture of DSO over a longer period by using average daily sales figures, but they require more frequent calculations and may be more time-consuming. The Countback Method relies on historical data to estimate DSO, making it useful for forecasting, but it may not be appropriate for companies with highly seasonal sales patterns.
Ultimately, the best way to calculate your DSO will depend on your organization's specific needs, the availability of data, and the time and resources you have available for calculation and analysis. It may be a good idea to use multiple methods and compare the results to get a more complete picture of your DSO and identify any trends or patterns that can inform your business decisions.
Automate DSO Calculation to Improve Accounts Receivable Collection
What is the most efficient and accurate way to calculate your DSO? The best answer for many businesses is to use the Countback Method to calculate Days Sales Outstanding (DSO)— this method has great advantages but is also time-consuming and prone to human error. You can save time by automating the calculation with a tool like Tesorio, which offers an AR automation and management solution with advanced analytics and dashboards.
As a top accounts receivable software, Tesorio automatically calculates your financial ratios, including DSO, using several methods and connects with third-party apps, including your favorite ERP, eliminating the need to switch between different software or tables for the latest data.
By automating your DSO calculation, you can focus your energy on tasks that add more value, such as lowering your DSO by offering incentives for clients to pay early or reviewing your credit policy to improve your receivables process. Ultimately, improving your financial health and statements is a better use of your time than tedious calculations. Tesorio does the heavy lifting for you, so you can focus on achieving long-term success for your company.
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