Why Are You Lending Your Client Money?
Businesses that fail to monitor their key performance indicator (KPI) of Days Sales Outstanding (DSO) can face catastrophic consequences. DSO is a measure of how long your company’s invoices remain outstanding before they are paid. It is often used as an indicator of a company’s credit risk and financial health because it offers insight into the time lag between when a business sells its products and when it gets paid for them.
A high DSO indicates that clients take longer to pay which means that you are giving your clients an interest-free loan. Anyone extending credit needs to regularly review the credits especially as we enter a recession. Fortunately, there are things you can do to monitor and improve your DSO, and that’s what we’ll be looking at in this post.
Read on to learn more about DSO including what it is, why it’s important, and how you can use it to improve your business operations.
What is Days Sales Outstanding?
Before we delve into the metrics, let’s define “days sales outstanding”. It is a metric used by businesses to monitor their cash-management process. It measures how long a company’s sales are “outstanding” before they are collected.
In other words, DSO is the number of days from the date of the sale until the date that the client pays their invoice.
How is Day Sales Outstanding calculated?
The calculation for DSO can be done with the formula:
DSO = (Accounts Receivables / Net Credit Sales) X Number of Days
Example of how Day Sales Outstanding is Calculated
Your company reported a sales revenue of $5 million in September 2022, with $3 million in credit sales and $2 million in cash sales. The balance of accounts receivable at month-end closing is $1.5 million.
So the Day Sales Outstanding would be:
DSO = ($1.5 million/$3 million) x 30 = 15.
A DSO of 15 means that it takes an average of 15 days for your company to collect its receivables.
A higher DSO means that a company has financed its sales with AR with the hope of collecting its receivables in a short time. This is considered risky because there is always a chance that they will have trouble collecting their receivables and will not be able to pay back the loans.
A lower DSO means that a company has less debt and more liquidity and can pay back its loans more quickly. It’s worth noting that there is no recommended blanket range of DSOs that applies to all companies. The metric largely depends on what type of company you have and where you are operating.
Additionally, cash sales are excluded from the calculation as they have zero DSO due to the absence of a lag time between the sale date and the receipt of cash.
Why is DSO important?
First and foremost, it shows how quickly clients pay you. A shorter DSO indicates that clients pay you faster than a longer DSO, which translates into faster cash flow.
DSO can also be a red flag for potential financial issues, such as if your DSO stays at an unusually high level for a long period of time. This could indicate that a client is unable to pay you, or that they have no access to credit.
Many businesses even use DSO for making strategic decisions related to their operations, such as by deciding whether to extend payment terms to a specific client or deciding on the right payment terms to offer clients in general.
DSO is a Cash-Management Metric
Remember that days sales outstanding (DSO) is not a “profitability” metric. It is a cash-management metric that tells how quickly clients pay. It also indicates how much credit risk the company is taking on.
DSO is usually expressed as the number of days between when a client is billed and when the client pays. Remember, the client’s delay in paying is equivalent to a loan from you. Think of your accounts receivable in terms of the interest rate you pay on your operating loan.
Determining the Cause of a High DSO
There are several reasons a client’s DSO might rise. There could be a problem with collections, but there may also be a legitimate business reason for the delay in payment. For example, in a recessionary/pre-recessionary economy, some clients may be paying more slowly because they are concerned about their business cash flow, and they’re trying to conserve cash.
Another reason for a high DSO could be that you have not made it easy for the client to pay you. This is a challenge you need to solve.
Many businesses still do not have a credit card processor from the website or invoices integrated into their accounting system. This simply delays your ability to use that cash as you wait for the client to write and send a check, your bookkeeper manually records the information and then drives the check to your local bank branch to deposit it.
Either way, if you allow a high DSO then you are inviting future payment problems from your clients.
Six Ways to Improve Your DSO
You want your cash flow to remain healthy and to manage your risk, so take steps to reduce your DSO. The good news is that there are a few easy ways to do this.
1. Know your current DSO
The first step to improving your DSO is to know what your current number is. You can find this KPI in your dashboard or by using an online DSO calculator to get a rough idea of your current DSO. Once you have this data, you can create a plan to improve your DSO.
Before you can reduce your DSO, you have to know why it is high. You can break down your DSO by client type to see if there are any areas where you are struggling to collect payment. Keep in mind that longer payment terms may be a sign you’re dealing with clients that are not financially sound.
2. Ensure you are only selling to credit-worthy clients
One mistake that can hurt your DSO is to sell to clients who don’t have the financial ability to pay for your product. To avoid this, make sure that you are only selling to clients who can afford to pay for the product and are likely to pay you on time. You can do this by requiring all clients to sign a contract that describes the terms of the sale.
You can also confirm that the client has the financial ability to pay before selling the product by running a credit check or requiring the client to pay a deposit before the sale is complete. If you sell high-priced products, require payment at the time of sale so you’re not financing their purchase.
3. Integrate your payment process with your invoicing
Since the pandemic, payment processing software has been one of the hottest industries. Within the MSP space in 2022, both ConnectBooster and WisePay were purchased by Kaseya and ConnectWise respectively. Those two software companies see the value of integrating a payment function directly into invoices, it allows clients to pay you easily. If there is one rule about payments it is this:
Make it easy for your clients to pay you.
Using integrated payments with your invoicing allows you to expedite the client experience by giving them the ability to make life easier.
A fluid invoicing integration with your accounting and/or PSA makes it easier to track sales throughout the month, send invoices to your clients and clients and know your numbers. This can help you track your DSO by making it easier to see how long each sale took to complete.
4. Set a payment deadline and stick to it
A great way to increase the speed your clients pay their bills is to set a payment deadline. Net 10, 15 and 30 are common. This is the date on which you expect clients to pay their bills. You can set this date on your invoice and remind your clients of it every time you send them a bill. By setting a payment deadline and sticking to it, you can increase the pressure on your clients to pay their bills quickly.
If you are comfortable with it, the absolute best way to ensure proper payment is to completely stop services if your client is outside of the payment terms. If you are offering monitoring services, email hosting or security, turn it off when the client has not paid for it. This sends a strong signal that you are not their banker. If they are late on an invoice, stand firm and don’t sell them more services or product until they’ve paid for the overdue invoice.
5. Don’t extend credit without reason
As mentioned above, extending vendor credit to your client requires you to consider the creditworthiness of your client. This should involve a credit check from their existing vendors. If you are not willing or able to perform this level of due diligence, do not sell on credit. Credit is money that you are allowing clients to borrow from your business and it uses your cash to finance.
When possible, say ‘no’ to being a bank.
If you have to offer credit to clients, try to do so for a specific reason and you should always make sure that the client has the financial ability to repay you. As mentioned, you can do this by running a credit check or requiring a deposit from the client. If it is a client that’s been with you for a while, check their payment history and only extend credit to qualified clients.
6. Be proactive with collections
The best way to improve your DSO is to not sell on credit. The second best way is to collect payment as soon as possible. Be proactive with collections and work to get paid as quickly as you can. Make fast collections a characteristic experience of doing business with your company.
You do not want to get into the world of collections, however, if you do, it is important to know the rules and regulations regarding debt collection. You can find information about debt collection laws on the Federal Trade Commission website. There are also tools that can help you become more proactive with your collections. Collections is very painful and will tarnish your brand. Staying on top of your accounts receivable mitigates this pain point.
Take your cash flow seriously with DSO
Days sales outstanding is an important metric that tells you how long it’s taking for your clients to pay your invoices. The more time you allow to elapse between when you sell your product or service and when you get paid for it, the more time you are financing their business with an interest-free loan.
In late 2022, as the world is ‘staring down the barrel’ of a recession, financing your clients’ business is not something you want to do. Fortunately, by following the tips outlined in this article, you’ll be able to reduce your DSO and improve your cash flow so you can continue to expand as your competition deals with collections.
Connect with us today and we can get you started.