Many businesses sell products to its customers on credit, giving them more time to pay for the product or service. Days Sales Outstanding (DSO) allows businesses to monitor how long it takes the business to collect money from its customers.
Business Sales and Outstanding Invoices
Many businesses allow their customers to purchase products and services on credit. The customer would receive the product or service when they request it, and agree to pay for the product or service within a given amount of time specified by the business. The most common payment terms for credit sales are 30, 60, and 90 day terms. This basically means that the customer will agree to pay in full for the product or service in 30, 60, or 90 days.
What happens when the customer fails to pay for the product or service within the agreed upon time frame? The accounts receivable function of the business attempts to collect money from the business's customers and encourage timely payment of invoices. This function of the business is very important, as it focuses on turning sales into cash.
Days Sales Outstanding Definition
The days sales outstanding (DSO) formula calculates the average amount of days it takes a business to collect money from its customers. This formula is used by management and outside investors to get an idea on how long it normally takes a business to receive cash from credit sales. This formula is important to management because it allows them to assess how quickly cash generated from sales can be used for business operations. This formula also gives management insight on how productive the business's accounts receivable department is. Investors are interested in this formula because it enables them to assess how quickly the business can get its hands on cash from its sales in order to successfully pay its liabilities.
The Days Sales Outstanding Formula
The formula used to calculate days sales outstanding is as follows:
Days Sales Outstanding = (Accounts Receivable / Net Credit Sales) x 365
The accounts receivable balance is located in the current assets section of the company's balance sheet. This figure represents the total amount of sales made that have not yet been paid for in full by the business's customers. Gross credit sales, or sales revenue, is located on the company's income statement. Net credit sales is equal to gross credit sales minus any sales returns, discounts, or allowances. Let's look at the example below to get a better understanding of how to calculate days sales outstanding:
ABC company reported an accounts receivable balance of $200,000 on its balance sheet for the year ending December 31, 2015. The company had net credit sales in the amount of $750,000 for the year. Based on this information we would calculate days sales outstanding as follows:
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Days Sales Outstanding = ($200,000/$750,000) x 365
Days Sales Outstanding = .27 x 365 = 97.31
The above calculation indicated that, on average, it takes ABC company approximately 97 days to collect money from its customers. Standard payment terms ABC Company sets for its customers is 60 days. Therefore, the company is not currently doing a good job collecting money from its customers on time. Management might implement efforts to increase the efficiency of its accounts receivable department to reduce the days sales outstanding. Management may also spend less money on other operating activity for the company to make sure it doesn't run out of cash.
The days sales outstanding (DSO) is the average time it takes a company to collect money from its customers. Days sales outstanding is equal to accounts receivable divided by net credit sales, then multiplied by 365. This figure gives management insight on how efficient the company's accounts receivable department is and how much cash the company can spend. This figure also lets investors know how much cash the company has access to in order to cover the company's debts.
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