In today's market place, it is very common for a business to extend credit to it's customers. Extending credit is a great way to reach a segment of customers that may not have the cash flow to pay the full amount up front. And while extending credit can be great for businesses, it can also hurt them, without even realizing it.
The old saying is true, cash is king! It is the lifeblood of your business. Without it, you can't survive. Therefore, a key metric to watch as a small business owner, is your Daily Sales Outstanding, or DSO.
Investopedia defines DSO as: A measure of the average number of days that a company takes to collect revenue after a sale has been made.
The calculation is as follows:
Accounts Receivable / Total Credit Sales X Days in Period
Let's take a loot at an example to demonstrate.
Say your company started the month with $1,000 in receivables. Throughout the month you made an additional $500 in credit sales, making the accounts receivable total $1,500. You also had customers pay $400 on previous credit sales. So at the end of the month, the accounts receivables balance totaled $1,100. If you want to calculate the DSO for the month, you would plug in the numbers as follows:
$1,100 (accounts receivalbe) / $500 (credit sales for the month) X 31 days = 68.2
Since DSO is a financial KPI, it is best tracked over a period of time, typically month to month. You as the business owner are looking to see if the trend is moving higher or lower!
Ways to Improve DSO
Invoicing System
The easiest way to reduce DSO is to invoice customers as soon as the purchase is made. The longer it takes for a customer to receive an invoice, the longer it will take to receive cash.
Discounts
Another great way to decrease DSO is by extending discounts. You have probably seen this before, or you may currently offer these incentives, where customers receive a discount if they pay within a certain time frame. Typically net/10 with a percentage discount. This tells the customer that if they pay within 10 days of receiving the invoice, they will receive a discount equal to the percentage amount offered.
Get Rid Of Bad Customers
While this can be difficult to do, it can save your businesses cash flow. If your average DSO is 31 days and you have a customer that typically pays 60 days after invoicing, it is time to let them go. The key to the decision to fire bad customers is a matter of costing, which your bookkeeper can help you determine. Every activity your firm engages in has a cost, and hopefully these activities average out to be more profitable than costly. Extra collections activities, second and third invoices, and the lost use of the cash can be calculated so you can determine whether or not a customer is really worth keeping around.
Conclusion
Determining your company's DSO is a critical factor in understanding your business' cash flow. Knowing how long on average it will take to receive funds, provides you with insight on whether or not you have enough cash to cover basic expenses. Finding ways to reduce your DSO is a proven method for increasing your business' cash flow.
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