A comparison of the receivables to the sales activity of a business is called the accounts receivable collection period or days sales outstanding. This comparison is used to evaluate how long customers are taking to pay a company. A low figure is considered best, since it means that a business is locking up less of its funds in accounts receivable, and so can use the funds for other purposes. Also, when receivables remain unpaid for a reduced period of time, there is less risk of payment default by customers.
Days sales outstanding is most useful when compared to the standard number of days that customers are allowed before payment is due. Thus, a DSO figure of 40 days might initially appear excellent, until you realize that the standard payment terms are only five days. DSO can also be compared to the industry standard, or to the average DSO for the top performers in the industry, to judge collection performance.
A combination of prudent credit granting and robust collections activity is indicated when the DSO figure is only a few days longer than the standard payment terms. From a management perspective, it is easiest to spot collection problems at a gross level by tracking DSO on a trend line, and watching for a sudden spike in the measurement in comparison to what was reported in prior periods.
To calculate DSO, divide 365 days into the amount of annual credit sales to arrive at credit sales per day, and then divide this figure into the average accounts receivable for the measurement period. Thus, the formula is:
Average accounts receivable ÷ (Annual sales ÷ 365 days)
For example, the controller of Oberlin Acoustics, maker of the famous Rhino brand of electric guitars, wants to derive the days sales outstanding for the company for the April reporting period. In April, the beginning and ending accounts receivable balances were $420,000 and $540,000 respectively. The total credit sales for the 12 months ended April 30 were $4,000,000. The controller derives the following DSO calculation from this information:
(($420,000 Beginning receivables + $540,000 Ending receivables) ÷ 2) ÷
($4,000,000 Credit sales ÷ 365 Days)
$480,000 Average accounts receivable ÷
$10,959 Credit sales per day
= 43.8 Days
The correlation between the annual sales figure used in the calculation and the average accounts receivable figure may not be close, resulting in a misleading DSO number. For example, if a company has seasonal sales, the average receivable figure may be unusually high or low on the measurement date, depending on where the company is in its season billings. Thus, if receivables are unusually low when the measurement is taken, the DSO days will appear unusually low, and vice versa if the receivables are unusually high. There are two ways to eliminate this problem:
- Annualize receivables. Generate an average accounts receivable figure that spans the entire, full-year measurement period.
- Measure a shorter period. Adopt a rolling quarterly DSO calculation, so that sales for the past three months are compare to average receivables for the past three months. This approach is most useful when sales are highly variable throughout the year.
Whatever measurement methodology is adopted for DSO, be sure to use it consistently from period to period, so that the results will be comparable on a trend line.