The number of days that it takes for a company to collect cash from customers.

Businesses calculate days sales outstanding (DSO) to track how quickly they're getting paid by customers. Businesses need to ensure that they're being paid within a reasonable amount of time so their cash flow remains healthy. If customers pay on time, companies will have the working capital necessary to buy additional inventory or to invest in their business. If customers don't pay on time, DSO will rise and the business may run short of cash.

What Is Days Sales Outstanding (DSO)?

Days sales outstanding (DSO) is an accounting metric that measures the average number of days it takes a business to receive payment for goods and services purchased on credit. The lower the DSO, the faster payments are collected. The higher the DSO, the longer it takes the company to see its money.

DSO is one part of the order-to-cash cycle, which starts with a customer ordering an item or service and ends with the company's receipt of payment from the customer. Steps in between include order entry, fulfillment, shipping, invoicing, collections and payment processing. DSO is also part of the cash conversion cycle (CCC), which measures the length of time between when a company purchases inventory until it receives payment from customers who buy it.

DPO vs. DSO:

DPO stands for days payable outstanding. It measures the average number of days it takes for a company to pay what it owes to suppliers, vendors and financiers. On the flip side, DSO measures the average number of days it takes for the company to receive payment from its customers for their purchases. A knowledge of how both financial ratios are trending can help managers and potential investors understand the company's cash flow.

Key Takeaways

• DSO measures how long customers take to pay their bills.
• When DSO is high or rising, managers should look into the financial health of their customers and try to understand why they are taking longer to pay.
• A high or rising DSO may also indicate a need to improve the billing/AR/collections process.
• Maintaining a healthy DSO range is one way to keep a business's cash flow strong.

Days Sales Outstanding Explained

Businesses may extend credit to customers, allowing them to purchase a product today and pay for it within an agreed-upon time in the future. The amount a customer owes is an account receivable (AR) on the business's books. How long it takes the customer to pay what's owed is known as DSO. Cash sales are not included in the calculation since payment is received upon purchase. A low DSO implies customers are paying their bills quickly, yielding a quick conversion of credit sales to cash, which bolsters a company's cash flow and working capital. A DSO of 45 days or less is considered low.

Why Is DSO Important?

DSO and whether it's low or high provides insight into how long a company holds customer debt, which in turn impacts its cash flow, a leading indicator of a company's financial health and ability to repay its own obligations. DSO reveals how quickly payments are received after an invoice is issued, reflecting the efficiency — or not — of the company's AR and collections processes, level of customer satisfaction and potential issues, such as whether a customer is having financial difficulties.

The Average Collection Period represents the number of days that a company needs to collect cash payments from customers that paid on credit.

How to Calculate Average Collection Period

The average collection period signals the effectiveness of a company’s current credit policies and A/R collection practices.

The average collection period measures a company’s efficiency at converting its outstanding accounts receivable (A/R) into cash on hand.

On the balance sheet, the accounts receivable (A/R) line item is a current asset that captures the value of owed payments from customers to a company for products and/or services already delivered, i.e. an “IOU” from customers who paid using credit as opposed to cash upfront.

Since the collection period refers to the number of days it takes a company on average to collect cash from credit purchases, companies strive to reduce the time needed as they mature to increase their near-term liquidity.

• Shorter Collection Period → Efficient A/R Collection Process
• Longer Collection Period → Inefficient A/R Collection Process

If a company is incapable of quickly obtaining cash from customers for goods/services already delivered (and “earned”), the company might need to implement changes to its policies to counteract the time lag between delivery and cash receipt.

In short, the average collection period answers the question:

• “How many days does it require a company to receive its owed cash payment from credit purchases?”

Therefore, the working capital metric is considered to be a measure of liquidity risk.

• Less Accounts Receivable Outstanding → More Short-Term Liquidity
• More Accounts Receivable Outstanding → Less Short-Term Liquidity

In order to calculate the average collection period, the company’s accounts receivable (A/R) carrying values from its balance sheet are needed along with its revenue in the corresponding period.

More specifically, the company’s credit sales should be used, but such specific information is not usually readily available.

Average Collection Period Formula

The formula for calculating the average collection period is as follows.

Average Collection Period = (Accounts Receivable ÷ Net Credit Sales) × 365 Days

The calculation involves dividing a company’s A/R by its net credit sales and then multiplying by the number of days in a year, in which either 360 days or 365 days can be used.

Because revenue is from the income statement, a financial statement that covers a period of time, whereas A/R is from the balance sheet, a “snapshot” at a point in time — it is acceptable to use the average A/R balance.

However, using the average balance creates the need for more historical reference data.

As an alternative, the metric can also be calculated by dividing the number of days in a year by the company’s receivables turnover.

Formula

• Average Collection Period = 365 Days ÷ Receivables Turnover

The receivables turnover estimates the number of times that a company collects owed cash payments from customers per year, and is calculated as the ratio between the company’s credit sales and its average A/R balance.

Average Collection Period — Excel Template

We’ll now move to a modeling exercise, which you can access by filling out the form below.

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Average Collection Period Example Calculation

Suppose a company generated $280k and $360k in net credit sales for the fiscal years ending 2020 and 2021, respectively.

In 2020, the company’s ending accounts receivable (A/R) balance was $20k, which grew to $24k in the subsequent year.

Our model assumptions are as follows.

• 2020A:

• • Net Credit Sales = $280k
  • Accounts Receivable (A/R) = $20k

• 2021A:

• • Net Credit Sales = $360k
  • Accounts Receivable (A/R) = $24k

• Number of Days in Year = 365

We’ll use the ending A/R balance for our calculations here.

If the average A/R balances were used instead, we would require more historical data.

Using those assumptions, we can now calculate the average collection period by dividing A/R by the net credit sales in the corresponding period and multiplying by 365 days.

• 2020A = ($20k ÷ $280k) × 365 Days = 26 Days
• 2021A = ($24k ÷ $360k) × 365 Days = 24 Days

From 2020 to 2021, the average number of days needed by our hypothetical company to collect cash from credit sales declined from 26 days to 24 days, reflecting an improvement year-over-year (YoY).

In the next part of our exercise, we’ll calculate the average collection period under the alternative approach of dividing the receivables turnover by the number of days in a year.

• 2020A = $280k ÷ $20k = 14.0x
• 2021A = $360k ÷ $24k = 15.0x

Upon dividing the receivables turnover ratio by 365, we arrive at the same implied collection periods for both 2020 and 2021 — confirming our prior calculations were correct.

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