15. july 2022
True DSO: better and more reliable than the traditional DSO metric
Benjamin from Veita
Author
If you analyze your receivables the way most companies do - with Days Sales Outstanding (DSO) - you probably know less about your receivables than you think. There's a better metric that can also improve your cash flow forecasts: True DSO.
Traditional DSO ratio: easy to calculate, but with pitfalls
In difficult economic times, it is particularly important to keep an eye on receivables from your own customers. Unfortunately, however, the conventional approach to assessing receivables management is seriously flawed. The most widely used key figure in receivables management is days sales outstanding, also known as days sales outstanding (DSO). It is usually calculated by dividing the days sales outstanding by the average daily sales volume. If you calculate this metric month by month, you can supposedly see the trend in how your customers are paying their invoices. However, this is often not true and, in the worst case, can lead to misjudgements in receivables management.
More than ever, numbers drive the business world - as calculations become ever tighter, supply chains ever longer, and interdependencies between business partners and companies ever more complex. The most important key performance indicators (KPIs) should provide a quick overview of where the company stands financially and what courses of action are available. For example, information on how many days a company waits for payment of its customer invoices is an important basis for far-reaching business decisions. The familiar key figure DSO (Days Sales Outstanding) is supposed to provide information here. The problem is that in some cases it does not provide this information.
How is the DSO key figure calculated?
The Days Sales Outstanding (DSO) can be calculated very easily with this formula:
The DSO is often calculated on the basis of a year, in which case the formula is (receivables : gross sales in the year) x 365. However, it is also possible to consider other periods, such as months. Unfortunately, as easy as the calculation is, the result is not very meaningful. The core problem of the traditional DSO ratio is that the result is influenced by two factors that have nothing to do with how quickly customers pay:
- Influence factor 1: Fluctuations in sales revenue
Influence factor 2: Selected period used for the calculation of average daily sales
To illustrate the problem, we will look at two case studies based on the sample company GmbH. In both case studies, the sample company GmbH generated sales revenues totalling € 900,000.00 in the three months from January to March. The sample company GmbH gives its customers a payment term of 45 days in each case. All customers pay their invoices on time on the due date, i.e. on the 45th day after the invoice is issued.
Case study 1: DSO ratio with fluctuating sales revenue
Let us assume that the sales revenues of the sample company GmbH develop differently in the three months January to March. The total for the three months remains the same. The sales revenues can from month to month:
As the figures in the graph show, the results differ significantly when we calculate the DSO ratio for January to March for each scenario.
When customers pay on time, but recently a higher volume of orders has been generated, the sum of receivables increases - and with it Days Sales Outstanding. So although a very reliable customer base has ensured a healthy increase in sales, the key figure (and supposedly the payment behavior of customers) seems to be developing negatively.
Conversely, a lower volume of orders and a declining total of receivables - and thus Days Sales Outstanding - suggests an improvement in the ratio and better payment behavior on the part of customers.
Case study 2: DSO ratio with changing observation periods
Let us assume that the sales revenue of the sample company GmbH increased from month to month in the three months from January to March. The total amount for the three months is € 900,000. For a time series comparison, the sample company GmbH evaluates different periods:
- 1 month or 30 days (scenario 4)
- 2 months or 60 days (scenario 5)
- 3 months or 90 days (scenario 6)
As the figures in the graph show, the results differ significantly when we calculate the DSO ratio for each scenario for the observation periods of 30 days, 60 days, and 90 days, respectively.
Depending on the period for which the DSOs are calculated, the results can vary significantly. Here, too, fluctuations in revenue over the period under review mean that the DSO may appear too low or too high compared with the actual payment behavior of customers. In these cases, it is therefore not possible to derive any reliable findings from the level and development of the traditional DSO indicator.
Despite the limitations, there is nevertheless a good reason to resort to the traditional DSO calculation. If you want to carry out benchmarking, i.e. a comparison between companies, you usually only have the published annual financial statements or quarterly reports as a source of information. From the financial reports, you can obtain the annual or quarterly sales as well as the receivable balances as of the balance sheet date. However, if you have access to internal information, it is better not to use the traditional DSO metric to assess your receivables management.
Robust insights thanks to "True DSO"
A more reliable alternative to the traditional DSO metric is the True DSO metric. Although it is a little more complicated to calculate, this metric does a much better job of representing what many people expect of it - namely, the amount of time a company has to wait for its customers' invoices to be paid. Here, the weighted runtime between invoice date and receipt of payment is used.
This is how the "True DSO" key figure is calculated
To calculate the True DSO, the individual invoice totals are each multiplied by the period until payment is received. The result is divided by the sum of all invoices.
This type of calculation allows a very accurate representation of the actual average days sales outstanding. The calculation correctly reflects the payment periods even in the case of partial payments.
Modern receivables management uses reliable data.
Fortunately, no one has to calculate key figures with a slide rule anymore. So it seems all the more logical to use not only modern technology, but also modern KPIs. Contemporary receivables management should be based on valid data - and interpret it in the right way. Because those companies that can draw important insights from existing data are clearly at an advantage today.
Always keep an eye on important key figures with VEITA
VEITA, a Potsdam-based start-up, offers a smart way to keep track of receivables management across teams. VEITA's intuitive cloud solution brings invoices, payments and customer communication together in one place - and presents the most important key figures and developments in clear charts. The founders have placed great emphasis on state-of-the-art methods such as True DSO and other contemporary KPIs. This means that reliable forecasts of incoming payments and cash flow can be made ad hoc at any time.
Live demo shows True DSO in action
An exclusive live demo of VEITA's cloud solution is the perfect opportunity to see a quick-to-record display of True DSO and other metrics in action. Managing Director Pierre Stengel and his team will be happy to arrange a virtual appointment with interested parties for a free presentation using real examples.
