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Using DSO to Measure Collection Efficiency

Using DSO to Measure Collection Efficiency

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Published by PATMON
Collection Efficiency
Collection Efficiency

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Published by: PATMON on Apr 04, 2008
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11/11/2011

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Using DSO to Measure Collection Efficiency 
Credit executives have an abundance of measures available to help them quantify and analyze the success of their efforts. One of the most widely used (and some credit executives might say, misused) measures is DaysSales Outstanding, or DSO.Days Sales Outstanding expresses the average time, in days, it takes your company to convert its accountsreceivables into cash. There are several ways to calculate DSO. When used appropriately and consistently, thesecalculations can help you answer a variety of questions about the effectiveness of your credit and collectionpolicies and practices. For instance, are your credit terms in line with competitors? Are your collectionprocedures successful in meeting stated goals? Is your customer base risky?Before discussing the various DSO formulas, a few words about making DSO, or any performance measuremeaningful. There are basically six requirements (as outlined in "Performance Measures for Credit, Collectionsand Accounts Receivable"):1.The measure should express a value that complements and supports the objectives of your company anddepartment.2.It must be communicated to all individuals responsible for the process being measured.3.It must be compared to some standard, for instance, past company performance, or an industrybenchmark.4.It must be used consistently, from month to month, year to year.5.The results should elicit some action - correcting course, managing change for improvement.6.It should provide a benefit. This could be as basic as the satisfaction of reaching a goal that contributesto the organization’s success.
Formulas for Calculating DSO
DSO is important as a financial indicator to the extent that it shows the age, in terms of days, of an organization'saccounts receivable and the average time it takes to turn those receivables into cash.It can give insight into the changes occurring within an organization's receivable balance; indicating whether achange occurred because of a positive or negative fluctuation in sales during that period, or if other businessfactors such as promotional discounts, seasonality, selling terms, etc. created the effect.Each method for calculating DSO (outlined below) has its own strengths, and each is based on what might becalled the
Standard DSO
formula. The key to making effective use of any of these tools is consistency. Select themethods that work best for you and stick with them.For each of the example DSO calculations that follow will use the same receivables data, listed below. The datefor on which the DSO is calculated will be September 30, 2004.
 
Date of InvoiceAge BucketDollars in BucketCredit Sales in Period
9/28/04Current$3,000$5,0008/28/041-30 days past due$3,000$6,0007/28/0431-60 days past due$2,000$5,000
Total Open Receivables
$8,000$16,000
Sales Periods (for consistency):
Annual = 365 days
 
Six Months = 182 days
Quarter = 91 days
Month = actual # days in the monthNote that since the data utilized is limited and quite simple, the various DSO calculations should be close toequal.
Standard DSO Calculation
The
Standard DSO
calculation provides an average (aggregate) time in days it takes to convert accountsreceivables into cash. It should be tracked over time and compared to previous company results or industry/competitor benchmarks.
Standard DSO Formula
and calculation utilizing data above:(Ending Total Receivables / Total Credit Sales) x Number of Days in PeriodFor the 3
rd
Q: ($8,000 / $16,000) x 91 =
45.5 days DSO
Best Possible DSO Calculation
Best Possible DSO
utilizes only your current (non delinquent) receivables to calculate the best length of timeyou can achieve in turning over receivables. It should be compared to the standard calculation above, and beclose to your terms of sale. The closer your standard DSO is to your best possible DSO, the closer your receivables are to your optimal level.
Best DSO Formula
and calculation utilizing data above:(Current Receivables / Total Credit Sales) x Number of Days($3,000 / $16,000) x 91 =
17 days Best Possible DSO
Delinquent DSO (Average Days Delinquent) Calculation
Delinquent DSO
or Average Days Delinquent (ADD) calculates the average time from the invoice due date to thepaid date, that is,the average days invoices are past due. It provides a snapshot to evaluate individuals,subgroups or overall collection performance.
Delinquent DSO Formula
Standard DSO - Best Possible DSO = Average Days Delinquent45.5 - 17 =
28.5 average days delinquent
Sales Weighted DSO Calculation
Sales Weighted DSO
, as with the regular DSO calculation, measures the average time that receivables areoutstanding. However, it is considered by some an improvement over other methods of calculating DSO becauseit attempts to smooth out the bias of credit sales and terms of sale. (See Gallinger in Resources for Further Information below).
 
Sales Weighted DSO Formula
{($ in Current Age Bucket / Credit Sales of Current Period) +($ in 1-30 Day Age Bucket / Credit Sales one month prior) +($ in 31-60 Day Age Bucket / Credit Sales two months prior) +(etc.)} x 30{($3,000 / $5,000) + ($3000 / $6,000) + ($2,000 / $5,000)} x 30= (.6 + .5 + .4) x 30=
45 days Sales Weighted DSO
Countback DSO Calculation
Another method for calculating DSO that takes into account sales fluctuations is a formula called the
CountbackMethod
. According to an article in the June 2004 issue of 
newsletter, this method provides a moreaccurate picture of DSO and its month-to-month fluctuations in sales and past due receivables. It also gives moreweight to the current month’s sales, making the correct assumption that most of the A/R balance will be fromcurrent, as opposed to previous sales. And, it takes into account the real effect of the actual difference in thenumber of days per month (i.e. 28 in February vs. 30 in April, June, September, November vs. 31 the rest of themonths).The Countback Method can be used with any time frame. If terms are net 30, then monthly balances are used. If terms are net 10, weekly numbers might be used. This method involves three steps.
Countback DSO FormulaStep 1.
Days counted back = # of days in current month. September = 30
Step 2.
Calculate DSO for periods prior to step 1Month end net A/R balance - Current month’s sales= Prior Periods ReceivablesEx. $8,000 - $5,000 = $3,000 prior period's receivables
Note, if the prior period’s receivables is larger than the prior month’s sales, repeat step 1. The DSO will begreater than 2 months.
Prior Period = (Prior Periods Receivables / Credit Sales for Prior Period)x Number Days in Period (August has 31 days)Ex. ($3,000 / $6,000) x 31 = 15.5
Step 3.
Add DSO for previous period to days counted back in Step 1Ex. 15.5 + 30 =
45.5 Countback DSO
True DSO Calculation

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