If you search online, you will find countless articles and posts about DSO, some pro and some against the metric. While many companies use DSO as a method of benchmarking their receivable performance, there are some fundamental flaws in the calculation itself that make DSO a much weaker statistic than others that could be utilized. Unfortunately, far too many companies use DSO as a benchmark and for public companies, it’s a real statistic they measure and report. The reality is that DSO isn’t going anywhere and we have to find a way to work with its limitations so it can be more meaningful.
Beware of Geeks bearing Formulas- Warren Buffett
Whether you are for or against DSO, most agree that the formula itself is often the problem. Since the method for choosing the measurement criteria can vary from company to company, there is no consistent way to benchmark against other organizations. Some include all sales from a period or exclude receivables from a specific customer or group of customers. In the end, one can dilute the meaning behind the calculation until what’s left is a number that essentially has no real significance.
It is questionable that DSO can accurately manage performance. Many would argue doubtful. While DSO measures the time it takes to turn receivables into cash, too many outside variables can dilute the results. A sudden sales spike and the DSO will shrink accordingly. This does not however mean that the company is performing better or worse, it simply means that for one specific reporting period, the numbers were positive.
So what do I like about DSO? When considering other options, DSO offers a few convenient truths, most importantly that of consistency. DSO can be measured, as long as the numbers are available, at any time. It can be reported over long periods of time, measuring receivables against sales for as far back as the statistics will allow. So while the receivables and sales numbers may fluctuate, the methodology for calculating the DSO can remain the same. Reporting to everyone within the organization how the calculation was obtained will be critical to increasing the validity of the results.
I prefer to break DSO down into four categories, spotlighting specific trends or business issues that are either unpreventable or a variance that occurred through some instance. What I would report can be broken down into the following:
- True DSO- using the preferred or company approved method is necessary for cohesion within the business, especially if this number is also public. Diverging from this number will cause confusion and dilute the messaging to senior management. This would include all fluctuations in sales or receivables (push for new customer acquisition or merging acquired receivables into the existing portfolio).
- Level DSO- This is the start of asserting some control over the reporting. Level the DSO without specific variables. From a receivables perspective, measuring against a constantly fluctuating sales number can be challenging. Smooth out the sales number into an annual or quarterly average, thus leveling spikes in the sales org. Or back out acquisition receivables from the number to understand the impact of those receivables against the original portfolio.
- Variable DSO- Variable DSO starts to take into consideration internal business issues that are outside of receivables’ control. If, for example, your company has delays in installation of capital equipment, one might back out capital sales numbers that have exceeded their scheduled completion date. Still report on them, but understand what your business looks like without them.
- Segmented DSO- So perhaps your receivable is split based on customer type- product vs. service or commercial vs. consumer customers. Splitting the DSO (both sales and receivables numbers) helps target the area of the portfolio causing the most issue. Segmenting this way may also lead to a new AR strategy, as the focus can shift to the area of the business that makes the most impact.
Level, Variable and Segmented DSO all require messaging to the business as to why numbers were excluded or adjusted for reporting purposes. As the owner of the results, it’s going to be important to track and explain why certain numbers have been adjusted. Retain that information for consistency and future reporting. While basic DSO calculations mask certain issues within the organization and portfolio, using some analytics can make the measurement more meaningful and can be a useful barometer to drive change and maximize performance.