DSO Meaning: How To Interpret DSO For Your Business

Days sales outstanding, also known as DSO, is a fundamental financial metric a company can use to evaluate its efficiency and financial health. In its simplest form, DSO quantifies the average number of days a company takes to collect payment after making a sale on credit.

For any business, whether it’s a small startup or a large corporation, a firm grasp of DSO can help you maintain a healthy and steady cash flow. On an episode of the Shopify Masters podcast, Jean Wu, cofounder of the insulated bottle business Que, discusses the importance of financial vigilance.

“Not understanding financially how the business is doing, how the business is running, is pretty dangerous,” she says. Understanding metrics like DSO is necessary for a business to be “lean and healthy,” as Jean puts it.

Learn what factors can affect DSO, how to interpret this metric, and strategies for lowering it.

What is DSO?

DSO stands for days sales outstanding, and it measures the average collection period for credit sales. In a world where immediate cash sales are not always possible, especially in B2B transactions, companies extend credit to customers, allowing them to pay unpaid invoices later. DSO quantifies precisely how long that process takes.

Days sales outstanding is a key part of working capital management because it affects a company’s liquidity—its ability to meet short-term financial obligations. A consistently low DSO can be a competitive advantage. It demonstrates the company can convert sales into cash quickly, which can be used to fund operations, pay suppliers, or make investments. A rising DSO could be a red flag, pointing to possible issues with client credit quality, inefficiencies in billing, or a faltering collections strategy.

DSO formula

The standard formula financial professionals use to calculate DSO is:

DSO = (Accounts receivable / Total credit sales) x Number of days

• Accounts receivable. This is the total amount of money owed to the company by its clients for goods or services already delivered. Accounts receivable represents all invoices at the end of a designated time period that are unpaid.

• Total credit sales. This is all sales made on credit during the same time period. It is important to exclude cash sales from this figure to get an accurate representation of the credit collection cycle.

• Number of days. This is the number of days in the given period you are analyzing, which could be a month (30 days), a quarter (90 days), or a year (365 days).

For example, if a small business has an accounts receivable balance of $500,000 and credit sales totaling $2,000,000 over a 90-day period, its DSO would be calculated as:

• ($500,000 / $2,000,000) x 90 

• 0.25 x 90 = 22.5 days

On average, it takes the company 22.5 days to collect receivables from a sale.

Factors that affect DSO

A company’s DSO is not a static number; a combination of internal and external factors influences it. Understanding these influences is the first step toward managing your cash flow effectively:

Credit terms

The payment terms a company offers its clients influence the expected time frame for payment. While generous terms (e.g., net 60 or net 90) could attract more credit sales and higher sales volumes, it inherently increases DSO. Another approach is to use standard terms like net 30, or payment within 30 days.

Some businesses offer discounts for paying early to incentivize prompt payment. A classic example is “2/10 net 30,” which means a client receives a 2% discount if paid within 10 days; otherwise, the full amount is due within 30 days. It’s possible for a company to lower its DSO using this strategy.

Industry standards

An acceptable DSO is highly dependent on the industry standards and the company’s business model. A DSO that is excellent for a software company could be a red flag for a retail business. This is due to variations in payment terms, sales volume, and the complexity of billing.

Here are some examples of DSO trends in various industries, based on how many days is generally acceptable:

• Retail/ecommerce. These industries typically have a very low DSO that ranges from five to 20 days. This is because most transactions are either paid for at the point of sale (cash or credit card) or through automated, immediate online payments.

• Software as a service (SaaS). A good DSO for software-as-a-service (SaaS) companies generally ranges from 30 to 45 days. This is often in line with their monthly or quarterly billing cycles as well as the payment terms they extend to their customers.

• Manufacturing. This sector could have a higher DSO, usually between 45 and 60 days. Factors like longer production cycles, larger transaction values, and the practice of offering lenient credit terms to B2B clients can influence this.

• Professional services. For firms like consulting agencies, law firms, and accounting services, a good DSO is usually between 30 and 60 days. The exact figure varies based on the complexity of the project, the size of the client, and the firm’s specific billing cycles (e.g., hourly versus retainer). 

• Construction. This industry has one of the highest DSOs, often between 60 and 90 days, or even higher. This is due to the industry’s common use of project-based billing, which is often related to the completion of milestones and can involve complex invoicing and payment approval processes.

• Health care. Health care providers face a high DSO, with averages frequently ranging from 45 to 70 days. This is primarily because they must navigate a system of third-party payments and insurance claims, often causing significant delays.

Internal collections processes

The most significant factor within a company’s control is its internal collections process. This encompasses everything from the moment it sends an invoice to its final collection of money. An efficient process includes prompt invoicing, clear internal and external communications, and consistent follow-ups.

Jean says her business, Que, uses Zoho, a tool designed for inventory tracking and invoicing. 

“You can invoice your customer … and you can also track your inventory, which is important,” she explains.

By automating the company’s cash flow management, Que is able to ensure it’s tracking its sales, sending every invoice, and keeping the entire system well-organized.

How to interpret DSO

When comparing DSO across your industry, you may notice your own metric is higher or lower than the standard. While a low DSO could indicate an efficient collections process, a high DSO might mean there’s room for improvement. Here’s more information about interpreting a low or high DSO:

Low DSO

A low DSO means a company is excellent at converting sales into cash. This means it has an efficient collections process, good credit policies, and healthy client relationships. A low DSO means liquidity has increased, which allows the business to reinvest its profits, pay off debts, and take advantage of new opportunities without needing to rely on external financing. It’s a clear sign of a well-managed and financially stable operation.

High DSO

It is possible that a high DSO is a symptom of underlying problems. It can indicate a lenient credit policy, inefficient invoicing, or even a client base that struggles to make payments. A consistently high DSO can create a dangerous cycle. It strains the company’s cash flow, which makes it difficult to pay bills, suppliers, or employees on time. This could lead to short-term borrowing, which adds interest costs and further erodes profitability. 

How to lower DSO

• Offer early payment discounts
• Streamline invoicing
• Enforce credit policies
• Improve the collections process

Lowering your DSO is a strategy to improve working capital. While it requires your dedication, the benefits are worth the effort:

Offer early payment discounts

This is a powerful incentive for clients. By offering a discount for paying early, a business encourages prompt payment. The small discount is often a worthwhile trade-off for getting the funds into your accounts sooner. For example, offering a 2% discount if an invoice is paid within 10 days on a $50,000 invoice is a $1,000 discount for the client, but it gives the company access to $49,000 in cash 20 days sooner than the standard net 30 terms.

Streamline invoicing

The collections process begins as soon as sales occur. To collect receivables efficiently, invoicing must be accurate and timely. An incorrect or late invoice can lead to an inability to collect payment. Automating the invoicing system, such as what Que does with Zoho, ensures invoices are generated and sent immediately upon the completion of a sale. This reduces human error and establishes a clear start to the payment clock.

Enforce credit policies

A robust credit policy is another consideration for maintaining a low DSO. This includes defining payment terms and applying them consistently. When bringing on new clients, consider performing a credit check. For all clients, ensure late payment consequences are clearly outlined in your agreements. This prevents any misunderstandings and gives your company leverage to collect outstanding receivables.

Improve the collections process

The process of following up on unpaid invoices should be systematic and professional. Proactive cash flow management can make the biggest difference in these areas:

• Proactive reminders. Send gentle, automated reminders a few days before an invoice is due.

• Prompt follow-ups. Follow up immediately after an invoice is past due.

• Escalations. Establish a clear process for escalating delinquent accounts. This might involve a phone call from a senior staff member or, as a last resort, using a collections agency.