what is days sales outstanding (DSO)?

A friend of mine is potentially going to be acquired (they are in the early stages, pre LOI) and the acquirer asked the CEO to provide a few metrics of which one was DSO. He called in a panic and asked: what is that?

DSO or, days sales outstanding, is an interesting metric. Technically it is a measure of the average number of days that a company takes to collect on its invoices. But the number in relation to the industry standard, and the trend to prior quarters, is quite telling.

I see DSO as a measure of efficiency, solid process and good customer care. If you have a high DSO then your collections efforts are not that good (inefficient or over taxed finance department) and/or your ability to assess credit risk before a sale is made is poor and/or your sales themselves are a bit weak (e.g. products have issues, customer wasn’t ready to buy but you ‘worked out a deal’ with payment terms, services being provided are not meeting client expectation, customer care in general is poor, etc.). Remember, non-payment is the first sign that a customer is not happy. If you have a low DSO then your process is solid (efficient finance procedures for assessment and collection, solid sales cycle where the customer is satisfied). For small companies cash is king so it is always in the company’s best interest to collect receivables as quickly as possible.

How do you calculate it?

DSO is looked at either quarterly or annually. The formula is:

= Accounts Receivable / Total Revenue for period * Number of Days in period

where the number of days is either 91 (quarterly) or 364 (annually) in Canada; or 90 and 360 respectively if you are in the United States.

The industry standard is for DSO to be no more than 10-15 days longer than your standard terms of sale. So, if your standard terms are net 30 then you should be aiming for a DSO of approx. 45 days or less for ‘best in show’.

Now, back to my friend. Why does the acquirer want to know the DSO for the past eight quarters? Well, this is a large company that already has a solid finance team in house so it is not for efficiencies in collections efforts or credit risk (a scan of the customer list can quickly give them guidance on that). In this case they are using DSO to see if the company is masking any product, services or sales issues and when can they count on the cash being shown on the balance sheet. I have advised my friend to provide the metric but also include a brief summary of the finance team and their collections efforts and the type of customers who typically make up the largest part of the AR (e.g. if it is Microsoft, well, you know they can pay their bills) so that the acquirer can assess accordingly.

Just as a reference: their terms are Net 30 and their DSO for the most recent quarter was 77. In this case it was truly indicative of the finance team (part time, over taxed and not paying attention to converting invoices to cash quickly).