Using DSO to Measure Collection Efficiency

Credit executives have an abundance of measures av ailable to help them quantif y and analyze the success of
their efforts. One of the most widel y used (and some credit executiv es might sa y, misused) measures is Days
Sales Outstanding, or DSO.

Da ys Sales Outstanding ex presses the average time, in days, it takes your compan y to convert its accounts
receivables into cash. There are sev eral wa ys to calculate DSO. W hen used appropriatel y and consistentl y, these
calculations can help you answer a variety of questions about the effectiv eness of your credit and collection
policies and practices. For instance, are your credit terms in line wi th competitors? Are your collection
procedures successful in meeting stated goals? Is your customer base risky?

Before discussing the various DSO formulas, a few words about making DSO, or any performance measure
meaningful. There are basicall y six requirements (as outlined in "Performance Measures for Credit, Collections
and Accounts Receiv able "):

1. The measure should express a value that complements and supports the objectiv es of your compan y and
department.

2. It must be communicated to all indiv iduals responsible for the process being measured.

3. It must be compared to some standard, for instance, past compan y performance, or an industry
benchmark.

4. It must be used consistentl y, from month to month, year to year.

5. The results should elicit some action - correcting course, managing change for improvement.

6. It should provide a benefit. This could be as basic as the satisfaction of reaching a goal that contributes
to the organization’s success.

Formulas for Calculating DSO

DSO is important as a financial indicator to the extent that it shows the age, in terms of days, of an organi zation's
accounts receivable and the av erage time it takes to turn those receivables into cash.

It can give insight into the changes occurring within an organi zation's receiv able balance; indicating whether a
change occurred because of a positive or negative fluctuation in sales during that period, or if other business
factors such as promotional discounts, seasonality, selling terms, etc. created the effect.

Each method for calculating DSO (outlined below) has its own strengths, and each is based on what might be
called the Standard DSO formula. The ke y to making effectiv e use of any of these tools is consistenc y. Select the
methods that work best for you and stick wi th them.

For each of the ex ample DSO calculations that follow will use the same receiv ables data, listed below. The date
for on which the DSO is calculated will be September 30, 2004.

Date of Invoice Age Bucket Dollars in Bucket Credit Sales in Period

9/28/04 Current $3,000 $5,000
8/28/04 1-30 days past due $3,000 $6,000
7/28/04 31-60 days past due $2,000 $5,000
Total Open Receivables $8,000 $16,000

Sales Periods (for consistency):

• Annual = 365 days

 • Six Months = 182 days

• Quarter = 91 days

• Month = actual # days in the month

Note that since the data utili zed is limited and quite simple, the various DSO calculations should be close to
equal.

Standard DSO Calculation

The Standard DSO calculation prov ides an average (aggregate) time in days it takes to convert accounts
receivables into cash. It should be tracked over time and compared to prev ious company results or
industry/competitor benchmarks.

Standard DSO Formula and calculation utili zing data above:

(Ending Total Receiv ables / Total Credit Sales) x Number of Days in Period

For the 3 r d Q: ($8,000 / $16,000) x 91 = 45.5 da ys DSO

Best Possible DSO Calculation

Best Possible DSO utilizes onl y your current (non delinquent) receivables to calculate the best length of time
you can achieve in turning over receiv ables. It should be compared to the standard calculation abov e, and be
close to your terms of sale. The closer your standard DSO is to your best possible DSO, the closer your
receivables are to your optimal lev el.

Best DSO Formula and calculation utili zing data above:

(Current Receiv ables / Total Credit Sales) x Number of Days

($3,000 / $16,000) x 91 = 17 da ys Best Possible DSO

Delinquent DSO (Average Days Delinquent) Calculation

Delinquent DSO or Av erage Da ys Delinquent (ADD) calculates the average time from the inv oice due date to the
paid date, that is,the average days inv oices are past due. It provides a snapshot to evaluate individuals,
subgroups or overall collection performance.

Delinquent DSO Formula

Standard DSO - Best Possible DSO = Average Days Delinquent

45.5 - 17 = 28.5 average da ys delinquent

Sales Weighted DSO Calculation

Sales Weighted DSO, as with the regular DSO calculation, measures the av erage time that receivables are
outstanding. However, it is considered by some an improv ement ov er other methods of calculating DSO because
it attempts to smooth out the bias of credit sales and terms of sale. (See Gallinger in Resources for Further
Information below).
Sales Weighted DSO Formula

{($ in Current Age Bucket / Credit Sales of Current Period) +

($ in 1-30 Day Age Bucket / Credit Sales one month prior) +

($ in 31-60 Day Age Bucket / Credit Sales two months prior) +

(etc.)} x 30

{($3,000 / $5,000) + ($3000 / $6,000) + ($2,000 / $5,000)} x 30

= (.6 + .5 + .4) x 30
= 45 da ys Sales Weighted DSO

Countback DSO Calculation

Another method for calculating DSO that takes into account sales fluctuations is a formula called the Countback
Method. According to an article in the June 2004 issue of Credit Today newsletter, this method provides a more
accurate picture of DSO and its month-to-month fluctuations in sales and past due receivables. It also giv es more
weight to the current month’s sales, making the correct assumption that most of the A/R balance will be from
current, as opposed to prev ious sales. And, it takes into account the real effect of the actual difference in the
number of days per month (i.e. 28 in February vs. 30 in April, June, September, November v s. 31 the rest of the
months).

The Countback Method can be used with any time frame. If terms are net 30, then monthly balances are used. If
terms are net 10, weekly numbers might be used. This method involves three steps.

Countback DSO Formula

Step 1. Days counted back = # of days in current month. September = 30

Step 2. Calculate DSO for periods prior to step 1

Month end net A/R balance - Current month’s sales

= Prior Periods Receiv ables

Ex . $8,000 - $5,000 = $3,000 prior period's receiv ables

Note, if the prior period’s receivables is larger than the prior month ’s sales, repeat step 1. The DSO will be
greater than 2 months.

Prior Period = (Prior Periods Receivables / Credit Sales for Prior Period)
x Number Days in Period (August has 31 days)

Ex . ($3,000 / $6,000) x 31 = 15.5

Step 3. Add DSO for prev ious period to days counted back in Step 1

Ex . 15.5 + 30 = 45.5 Countback DSO

True DSO Calculation

True DSO calculates the actual number of days credit sales are unpaid by tracking indiv idual invoices to the
month of sale.

True DSO Formula

(inv oice amount / net credit sales for the month in which the sale occurred)
x number of days from inv oice date to reporting date (9/30/04)

September Inv oice = ($3,000 / $5,000) x 2 = 1.2 days

August Invoice = ($3,000 / $6,000) x 33 = 16.5 days
July Invoice = ($2,000 / $5,000) x 64 = 25.6 days

Sum of True DSO for all open inv oices = True DSO per total accounts receivable

1.2 + 16.5 + 25.6 = 43.3 True DSO

Benchmarking DSO

In general, if your compan y's DSO is no more than 10-15 days longer than terms of sale, the receivables are
turning into cash without much difficulty.

Benchmarking data for DSO is somewhat hard to come by, and even more difficult to find wi thout paying a fee.
The Credit Research Foundation (CRF) does a quarterl y study, the National Summar y of Domestic Trade
Receivables (a.k.a., the DSO Survey), that is an examination of the condition of A/R for U.S. companies. The CRF
has been collecting this data quarterl y since 1960. The results of the complete stud y are av ailable to CRF
members and those participating in the survey.

A view of the Summar y data for fourth quarter 2004 is available on the Credit-to-Cash-Advisor.com web site.

Outlined below is some very general DSO benchmarking information. You can get more specific and exhaustive
benchmarking information by subscribing on the web site of Strategic Adv antage .

# Cos.
SIC Code Industry Average DSO
in Sample
23xx Apparel & Other Textile Prods 40.6 40
25xx Furniture & Fixtures 52.2 27
26xx Paper & Allied Products 54.6 44
27xx Printing & Publishing 49.9 65
28xx Chemicals & Allied Prods 59.4 277
30xx Rubber & Misc Plastics 48.8 50
31xx Leather & Leather Prods 55.6 17
35xx Industrial Machiner & Equip 70.7 245
36xx Electric & Electronic Equip 51.9 407
39xx Misc Manufacturing 53.8 49
48xx Communications 47.9 201
50xx Wholesale Trade - Durable Goods 47.7 257
51xx Wholesale Trade - Nondurable 26.9 87
73xx Business Services 89.2 734
Resources for Further
Information

Olsen, Rob "Performance Measures for Credit, Collections and Accounts Receiv able ." Credit Research
Foundation web site.

"W hy You Should Switch to the Countback Method to Calculate DSO." Credit Today newsletter: June 2004, pg. 1

Gallinger, George W. "An Evaluation of Techniques for Monitoring Accounts Receivable." Columbia: NACM , 1995.

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reduce your DSO and improve cash flow. To find out more, visit the Accounts Receivable Outsourcing section of
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