I am in the process of producing a best practise of Key Performance Indicators for a typical Accounts Receivable department. This has involved performing market research with a number of different clients to understand what they currently use for performance tracking and what they aspire to use. There are a number of measures that should be considered and the one that is the most widely used is the “DSO” Days Sales Outstanding. This blog will look at the importance of the “DSO” and what factors influence the DSO.
How do you work out your DSO?
Before you can fully understand the points I make later in this blog it is important to have a clear understanding of what it does and how it is calculated. Below is a common formula that is widely used.
Total outstanding debt / Average Monthly sales * 30 days.
So if a client had a total outstanding debt that totalled $400 million and the Average Monthly Sales was $200 then the DSO would be 60
Please note this is a common methodology to calculate the DSO, you may find that your organisation does it slightly different.
The purpose of the report is to measure the outstanding debt. A client normally offers a customer a payment term, shall we say 30 days. The report measure the performance of the Accounts Receivable team to collect the money due from its customers.
If you imagine our client with average monthly revenue of $200 million and they have a standard 30 days payment term. After one month all invoices will fall due for payment, and at the month end the sales will be $200 million, and the amount of outstanding debt.
If things go to plan, and the next months sales are the same then in theory, $200 million would have been collected and therefore the DSO would be 30.
(200 / 200) * 30
Real life examples
In real life customers do not pay on time. They do not pay on time for a number of reasons. Without going into too much detail customers may have issues with paying for the goods they purchased, the invoicing may be wrong or the products faulty.
Most clients do not have a static monthly sales value. Companies will grow, and therefore their revenue will grow, and some customers may not sell as much as before. Seasonal impacts need to be considered as well, some clients will have busy months around Christmas if they are in retail for example whilst other clients perhaps in the service industry would be quiet during this period.
Averaging the monthly sales revenue over a year will remove some of the seasonal spikes however your monthly DSO will move around as well; as the month after higher than average sales periods will lead to higher volumes of cash to collect.
DSO reporting is normally performed at month end, however for comparisons it should be compared against the previous value for the last year, and against the previous month, taking into account any spikes.
Year on Year comparisons have value when the revenue is similar. Where a client grows by say 25% the volume of cash to collect will grow accordingly. Therefore performing year on year DSO values may need to take into account the new growth of the client.
To conclude the standard basic DSO calculation is only really beneficial for clients whose revenue stays pretty static and for month on month comparisons, there should not be seasonal spikes.
Other business factors
We have touched on the impact of the average monthly sales value has on the DSO calculation, however the total outstanding debt can also be influenced. Firstly, the Accounts Receivable team should be in control of this value. The Accounts Receivable team will try to collect as much of this as possible, removing the barrier for the customer to pay them. In general a good performance by the Accounts Receivable team will result in a lower Total Outstanding Debt value.
"At first sight if the outstanding debt amount here decreases year or year for a customer without a drop in sales, this should be deemed a success."
In most cases the basic synopsis above is correct; however as with everything there are exceptions to the rule. The main exception is the value of bad debt written off.
If we come back to our standard client with their $400 million of outstanding debt, if next year they drop this to $380 million this could be seen as a great success. However if for example the client “wrote off” $40 million of bad debt the picture may not be that great.
What is a bad debt?
A bad debt is where a customer has a group of invoices the client feels it has not chance of collecting. The debt sits within the balance sheet, however when a debt is written off, it is moved to the profit and loss and will reduce the total profit for the client.
In this example $40 million of the $400 was not collected, and the client felt that for a number of reasons there was no chance of them getting paid for this. This could be because a customer had been forced into bankruptcy or due a dispute with the customer over poor quality of goods. Either way the amount of outstanding debt has been reduced not by the positive actions of the Accounts Receivable team, but by factors outside of their control.
A DSO value can not be used in isolation to measure the performance of the Accounts Receivable team. Even when comparing against previous months or years performance, the DSO in isolation does not provide a true reflection on the performance of the Accounts Receivable team. If for example the Accounts Receivable Manager was measured and paid against the DSO it would not be fair to the client or the manager. The Manager could write off some bad debt to achieve his target, or the revenue of the client could dip meaning that achieving the target was easier than envisaged.
So what is the answer?
There is and can be no real single answer. This all depends on the client and factors influencing them. When considering the DSO I believe it is worth reviewing the turnover of the organisation and the level of bad debt. The Accounts Receivable Manager could be targeted to achieve a certain DSO, a certain level of bad debt write offs, but attention should also be made against the following areas that measure the true performance of their team.
Number of active customers against the number of customers contacted.
Number of promises to pay made against the number of promises to pay achieved
Number of disputes raised broken down by reason code
Duration of elapsed time to resolve customer disputes
Value of debt overdue for over 90 days