Managing the cash flow effectively is a nuanced challenge that every business confronts.
If neglected, it becomes an unseen threat, silently forging a financial bottleneck that obstructs growth.
Days Sales Outstanding (DSO) serves as a crucial indicator, providing a snapshot of the average number of days your business requires to collect payments after a sale.
According to Allianz Trade, businesses should set their sights on attainable and sustainable DSO reductions that resonate with their specific business conditions.
Neglecting DSO management can severely impact customer acquisition and retention, potentially straining your cash flow and threatening your business's fiscal health.
So, how can you effectively reduce DSO? What strategies can improve your DSO performance?
In this article, let’s explore five practical ways to improve your DSO
reduction strategy and provide actionable insights for better financial management in 2024.
Days Sales Outstanding (DSO) is a key financial metric that calculates the average number of days a company requires to collect payment after a sale has been made.
In simpler terms, DSO is a snapshot of a company's accounts receivable (AR) and reflects the average age of a company's receivables during a given period.
A lower DSO means that a company takes less time to collect a payment, which could signify efficient credit and collections processes.
On the contrary, a higher DSO indicates longer collection periods, potentially signaling issues with cash flow and customer payment practices.
Days Sales Outstanding (DSO) is calculated using the formula:
DSO = (Accounts Receivable / Total Credit Sales) x Number of Days.
Here's a table breaking down each component:
This refers to the length of the accounting period you are analyzing. For example, if you are calculating DSO for a quarter, you would use 90 days.
Imagine that your business recorded total credit sales of $20,000 for the quarter, and the accounts receivable at the end of this period was $60,000.
To calculate DSO, you would follow this formula:
DSO = ($60,000 / $20,000) x 90 days = 270 days.
This calculation indicates that, on average, it took 270 days for your business to collect payments after a sale was made during this quarter.
This extended DSO period suggests that a business may be facing challenges in collecting payments efficiently, potentially impacting the cash flow and overall financial health.
Implementing targeted strategies to reduce DSO could significantly improve your cash management and business operations.
Typically, a DSO of 45 days or less is considered healthy across most industries.
This standard suggests that companies are able to convert their receivables into cash within a short timeframe, which is crucial for maintaining liquidity and supporting operational needs.
However, this can vary; for example, industries with longer credit terms might see a good DSO as higher than 45 days.
Determining what constitutes a "good" Days Sales Outstanding (DSO) number can vary significantly depending on several factors including the industry norms, the size of your business, and specific operational practices.
According to a survey from the Credit Research Foundation, the median Days Sales Outstanding (DSO) in the fourth quarter of 2023 was 36 days.
The industry benchmark for Best Possible DSO was 30 days, with an Average Days Delinquent of approximately 3.95 days.
These statistics suggest that a DSO close to 36 days is currently seen as typical, though striving for lower figures like 30 days would be ideal for optimizing cash flow efficiency.
Cash flow is often likened to the lifeblood of any business—depicts the net movement of cash and cash equivalents into and out of your company.
DSO directly influences the liquidity of your business, and it reflects the time lag between a sale and the corresponding cash inflow. The longer it takes to collect
payments after a sale, the higher your DSO will be.
The delay in cash collection can lead to a potential cash crunch, affecting the capability to meet operational expenses, pay debts on time, or reinvest in growth opportunities.
If your Days Sales Outstanding (DSO) is increasing, you might face a challenging situation where you're generating sales, but the funds are not reaching your bank account promptly.
Want to get a better handle on how accounts receivables can shape your cash flow management? Check out the article on Accounts Receivables in Cash Flow Management and you might find this article insightful.
Here are five effective strategies to reduce DSO and maximize your company's financial performance:
Accuracy and timely delivery of your business’s invoices is one of the most impactful methods for reducing DSO.
Any invoice errors, such as incorrect quantities, wrong prices, or billing the wrong customer, can lead to disputes that delay payment. Similarly, late invoices can result in late payments.
Here are a few ways to improve invoice accuracy and timeliness:
- Implementing rigorous invoice reviews to confirm all details, such as customer information, services rendered, pricing, and payment terms are correct before dispatching.
- Automating the invoicing process with Constant, which integrates seamlessly with your financial applications and eliminates human errors and expedites the invoicing cycle. For example, once an invoice is approved in your accounting tool, Constant can automatically issue it to the customer.
- Training your team on the significance of accuracy and timeliness in the invoicing process. Constant supports setting up standardized processes and workflows to reduce manual effort and increase productivity.
Your credit policies can significantly influence your DSO. If you're extending credit to customers without a thorough evaluation, you might end up with a high DSO. Here's how you can enhance your credit management policies:
- Conduct a thorough credit check before extending credit to a new customer. This can clarify the customer's creditworthiness and help you avoid potential bad debts.
- Establish clear credit policies and make sure they are communicated clearly to your customers. This includes the credit period, late payment penalties, and any early payment discounts.
- Regularly review customer credit limits of your existing customers periodically. If a customer's creditworthiness has changed, you might need to adjust their credit limit accordingly.
Incentivizing your customers to pay their invoices early can be a powerful strategy for reducing DSO.
Early payment discounts, also known as cash discounts, are reductions in invoice amounts provided to customers if they pay their bills before the due date.
Here's how to effectively implement this strategy:
- Determining an attractive discount rate that should be enticing enough for customers to consider paying early. However, it should not significantly eat into your profit margins.
- Clearly communicate the discount policies to your customers and explicitly state the credit terms and highlighted on the invoices.
- Monitor the impact on DSO and keep track of how many customers are taking advantage of the early payment discounts and how it's affecting your DSO and profitability. Constant's financial dashboards provide a clear visual representation of your business financial operations, helping you measure performance metrics and monitor the impact of early payment discounts on your DSO.
Use automated invoicing and collection systems to reduce errors and speed up the collection process.
- Constant’s customer segmentation feature enables you to categorize customers based on payment behavior, invoice size, or customer value. This approach allows for tailored reminder messages that are more likely to result in timely payments.
- Set up dunning workflows customized to different customer segments on Constant. This flexibility allows you to adjust the tone, frequency, and type of reminders according to each customer's payment history and profile, ensuring that each communication is effectively targeted.
Invoice disputes can significantly delay payment, increasing your DSO. Here's how to streamline your dispute management:
- Implement a formal dispute resolution process in place to help customers resolve disputes quickly and efficiently. This process should include a clear method for customers to raise disputes and a timeline for resolving them.
- Embrace a dispute management system that can help track, manage, and resolve disputes more efficiently. These systems can help you maintain a record of all disputes, track their resolution status, and provide analytics to identify common issues.
- Monitor recurring dispute patterns which might indicate a larger issue that needs to be addressed. With Constant, you can gain access to analytical insights that help you identify patterns and trends, enabling you to resolve systemic issues that may be causing recurring disputes.
Recent trends strongly suggest that businesses greatly benefit from adopting automation in their Accounts Receivable (AR) processes.
A study by PYMNTS and American Express reveals that 62% of firms have seen improvements in their Days Sales Outstanding (DSO) through the implementation of AR automation technologies.
Automating critical functions like invoice delivery and payment acceptance not only reduces DSO but also enhances a company's resilience against future financial challenges.
Constant, a financial automation platform which can integrate with your entire financial tech stack, and equips organizations to streamline their AR operations, accelerate payment cycles, and reduce DSO.
With Constant, from tailored dunning to improved collections, you can simplify your AR processes—boosting efficiency, cutting costs, and strengthening your business against evolving market conditions.
To see how Constant can optimize your organization's DSO and improve your financial operational performance, consider booking a demo today.
