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Reducing DSO can improve cash flow, shorten your cash conversion cycle and boost your bottom line. Learn how to reduce DSO and build a healthy balance sheet.
Sufficient cash flow is incredibly important to business success. If your business hopes to meet stakeholder, investor and peer expectations, hitting your key performance metrics is crucial.
However, presenting a strong, cash flow-intensive balance sheet can be a challenge, especially if working capital is stuck in accounts receivable (AR). For small to mid-sized suppliers, lengthy customer payment terms are common, particularly during times of economic uncertainty. If you’re waiting months for invoices to clear accounts receivable, your working capital is most likely depleting — potentially jeopardizing business continuity and growth.
Fortunately, there are ways to disrupt long payment cycles and improve your company’s metrics quickly and easily. If your goal is to boost cash flow, one of the most important metrics to track is days sales outstanding (DSO). What exactly is DSO and how can you improve (lower) this metric?
Days sales outstanding is a measure of the number of days it takes for accounts receivable to collect cash from outstanding invoices. In other words, DSO measures how quickly it takes your customers to pay invoices.
DSO goes hand in hand with the cash conversion cycle (CCC), a metric that is used to evaluate the efficiency of a company’s operations and management, and which measures how long it takes to convert inventory investments into cash. The cash conversion cycle is calculated using the following formula:
CCC = Days Inventory Outstanding (DIO) + Days Sales Outstanding (DSO) – Days Payable Outstanding (DPO)
A low CCC indicates that you have a healthy cash flow and sufficient working capital, while a higher CCC indicates that you may lack the cash flow needed to operate and grow.
Maintaining a low DSO is crucial for keeping the cash conversion cycle to a minimum. There is no magic DSO number to aim for, but you can evaluate average DSO values among competitors and other businesses in your industry. Benchmarking your DSO against similar companies can help you determine what values are achievable.
In 2020, many customers began extending payment terms with suppliers — some as long as 90 to 120 days or more — to maintain cash flow as the economy slowed. Lengthy payment terms continue to challenge suppliers today as rising inflation and other market factors prompt customers to hold on to working capital. If your business has experienced lengthened payment terms, you may have a high average DSO and a longer cash conversion cycle as a result.
Days sales outstanding measures the average collections time across your customers. It’s a metric that is usually tracked monthly, quarterly or annually. To calculate DSO, divide accounts receivable by total sales in a given period, then multiply this number by the number of days in that period:
DSO = (AR / Total Credit Sales) x Days
For example, imagine that over 90 days, Supplier A amassed $100,000 in its accounts receivable and made $250,000 in sales. Supplier A’s DSO is 36, because:
$100,000 / $250,000 = 0.4 x 90 days = 36 DSO
With a DSO of 36 days, Supplier A is close to the average DSO value across industries of 37.3 in Q3 2022.
How thoroughly do you assess customer creditworthiness? A high DSO can signal customers that make late payments. Doing your due diligence with new customers is a proactive way to avoid late or nonpayments. Start by determining the level of credit risk your business is willing to accept. If you already have customers that pay late, you can apply these criteria to them. Ensure that your sales team is on board so that new customers with inadequate credit history don’t slip through the cracks, or consider using trade credit insurance to mitigate risk without turning away new business.
How does your business keep track of outstanding invoices? As part of your collections strategy, establish processes for prompt follow-ups. Investigating reasons for late payments is also valuable. For example, it may be possible to negotiate a payment plan or early payment incentive for customers that have cash flow issues of their own. Setting clear terms for late or nonpayment can also deter customers from missing due dates and reduce DSO. Negotiate financial penalties for late payments and consider dropping customers that consistently pay past the agreed term.
Customers are more likely to pay on time, or even early, if you send invoices as soon as possible. Invoicing software helps expedite the process, providing templates and automated payment reminders to streamline invoice creation and follow-ups. It can also help detect and correct errors that may otherwise extend payment timelines and raise DSO. Some businesses opt to time invoices strategically, sending them when customers are more likely to open emails and make payments — such as in the middle of the business day, midweek.
Four out of 5 US firms still use paper checks to pay bills. To avoid the delays caused by manual processes and paper-based systems, offer customers card, automated and/or online payment options. When customers can choose the payment method that’s most convenient for them, you’re more likely to get paid faster, increasing cash flow and lowering your DSO.
If you land a big customer, you may be tempted to accept its preferred payment timeline because you don’t want to harm the relationship by negotiating shorter terms. However, neither party benefits when extended terms deplete your working capital. Without sufficient cash flow, you might not be able to deliver goods or services on time and in full, which could jeopardize your financial stability or even create supply chain disruptions.
The first step is to assess your financial statements and determine how flexible you can afford to make your payment terms. Try to negotiate terms that suit the customer without putting your cash flow at risk. You can also leverage early payment incentives to reduce an otherwise lengthy DSO, especially if customers have rigid terms.
Early payment incentives are a cost-effective way to reduce DSO while strengthening your customer relationships. Put simply, these incentives give your customers a small discount in exchange for early payment. Many large customers already participate in early payment programs, making it easy for you to reduce DSO immediately. Here’s how it works with C2FO’s Early Payment program:
Unlike traditional early payment approaches, this model enables suppliers to choose when to request early payment and at what cost. This puts you in control of your DSO and increases cash flow — usually at a much lower cost than other working capital solutions such as borrowing, lines of credit or invoice factoring.
Days sales outstanding is a crucial metric for evaluating cash flow and ensuring your business has the working capital required to operate, meet customer demands and grow. Many small to mid-sized suppliers struggle to keep DSO at a reasonable level, especially as customers lengthen payment terms to raise their own bottom lines. The good news is that you can use simple strategies — from assessing customer risk to offering flexible payment options — to shorten DSO. If you need to take control of your DSO right now, early payment incentives are a good place to start.
Click here to learn more about early payment programs — or find out whether your customers already use C2FO so you can request early payment today.
This article originally published June 2020, and was updated May 2023.
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