Managing your cash flows regardless of the condition of economy of the country and size of your business is critical for the survival of your business. Managing cash flow in your business is an important activity to ensure that you can pay your expenses in a timely fashion and reduce the need to borrow to finance your operations.
One of the critical areas of business operation that affect cash flow is accounts receivable. Accounts receivable is comprised of the amounts due from customers that have bought goods or services on credit and it is one of the main components of working capital for all businesses, except for those who require payment at the time of sale.
Receivable management must be taken seriously due to the impact to the cash flow and survival of your business. When managing receivables, it is useful to track a small number of measurements to establish whether the designated activities are having an impact on working capital and the cost of receivables. In this article, we will focus on one key performance indicator (KPI) that will help you to monitor your cash inflows from credit sales; Days Sales Outstanding (DSO).
DSO is the most popular of all collection measurements. It will indicate the average number of days it takes the business to convert credit sales to cash. To calculate your DSO, divide 365 days into the amount of annual credit sales to arrive at the credit sales per day, and then divide this amount into the average accounts receivable for the measurement period. The formula is as follows:
Average accounts receivable
Annual credit sales / 365 days
A higher DSO will indicate that you have a potential problem in collections and a lower number will indicate that you are converting sales into cash effectively. DSO is most useful when compared to the standard number of days that customers are allowed before payment is due. A combination of prudent credit granting and robust collections activity is the likely cause when the DSO figure is only a few days longer than the standard payment terms.
Why DSO analysis is important?
Over time, businesses monitor their DSO to detect changes that may be adversely affecting their cash flow. As you review your own DSO’s, you should look for trends either up or down. A good trend is a declining DSO while an increasing trend is troubling for your business. For example, if your business sells on account at net 30 days and your DSO’s are at 75 days, this suggests there is a problem in your credit and collection activities and action should be taken. Furthermore, if you are required to pay your own bills within 30 days, it will become a much larger problem for your business as this gap widens.
What can you do if your DSO is trending upward?
If your DSO’s are trending up, there are a few areas to investigate and questions to ask.
• Is the credit and collection policy being implemented and adhered to consistently?
• Are you ensuring that customers establish their creditworthiness by performing credit checks or keeping limits lower until they prove they are creditworthy?
• Are you billing customers in a timely manner?
• Are you using an aging schedule and tracking past due accounts closely?
• Are there certain slow paying customers that are contributing to the trend and are you sending dunning letters or contacting them to follow up on past due invoices?
• Are you following up with past due accounts to ensure that the shipment was received and correct?
• Is the economy changing and having an adverse effect on customers’ ability to pay?
By answering these questions, you will be able to assess the reason for adverse trends in your DSO’s and formulate actions to improve the situation and ultimately improve your cash inflows. Take steps to improve your cash inflows, it could be the difference being in business or being out of business.
If DSO is increasing, the problem may be the processing of credit memos has been delayed. If there is a processing backlog, at least have the largest credit memos processed first, this will make the largest positive impact in your outstanding receivables.
If you need help improving your cash flow, there are several posts in this website that may answer some of your questions. If you want to boost your cash flow and customize a plan for your business contact me.