Cash is oxygen for any business, and especially for small businesses who usually find it harder to issue debt or secure loans. Making sales and issuing invoices does not immediately generate cash, payments on those invoices still need to be collected. To say it in accounting-speak, sales orders need to be converted to cash.
Advisors and accountants can boost small business performance by helping them track and improve the efficiency of their collections processes. One of the metrics accountants have relied on for over 100 years is Days Sales Outstanding — unfortunately it’s also very misunderstood and can be very misleading. It’s outdated too, now that we can quickly analyze all transactions via solutions like QuickBooks and Xero.
Just the words “days sales outstanding” seem to suggest that it will tell you the number of days that sales are outstanding. So a DSO of 30 could be expected to say that it takes an average of 30 days to collect payments. But no! What a DSO of 30 really means is that the amount of money in accounts receivable equals 30 days of average daily sales. Maybe that’s interesting, but it’s not a way to measure collections performance.
DSO ratio = accounts receivable / average sales per day
A big problem with the DSO calculation is it relies on that “average sales per day” number. Say payments are always received in exactly 30 days, guaranteed. Then you’d expect a constant, never changing DSO of 30. But if there’s a quick increase in sales, then average daily sales goes up and DSO falls even though collections stayed rock solid at 30 days. (Dive into one or two detailed examples.) You would be misled into thinking cash was being collected more quickly when it’s actually not! And that could lead to some uncomfortable mistakes forecasting cash flow.
Also, the different ways in which companies compute average daily sales means that you can’t compare DSO results to other companies. That doesn’t help collections benchmark their performance.
A few, but not many, advisors also compute the “true DSO.” This requires calculating the number of days between each invoice date and final payment date, and then calculating the average. Or better still, calculating the weighted average. And it works — if you have only one payment on each invoice!
True DSO = Σ(Paid Date - Sales Date) / Sale Count
True DSO = ∑(Amount of Each Invoice * (Payment date - Issue Date)) / ∑(Invoice Amounts)
We took True DSO a step further and developed an algorithm that works across any period and across any number of customers, and that handles partial payments. We first look at every individual payment, including those partial payments, and calculate the number of days between the payment date and the invoice date. Then we compute a weighted average days to pay across all invoices with payments during the period. We think the result is a more accurate measure of how many actual days it took to collect payments, and we call it the Tally DSO.
Tally DSO = Σ(Payment Amt * (Pay Date - Invoice Date)) / Σ(Invoice Amts with Payments)
Let us know if you have made other DSO tweaks of your own. We’ll also dig into other ways to measure collections performance in future posts, including the relatively new Collection Effectiveness Index.