The metric known as “days sales outstanding” (DSO), a gauge of credit-collection efficiency, is at a 10-year low for U.S. corporations—and that’s good news. To many, a low DSO means that a company is collecting its outstanding receivables quickly, and a downward trend suggests that the credit-collections process has grown more efficient.
In 2005, the average DSO for U.S. companies was 40.5 days, a 1.3-day drop from the year before, according to a new survey released by the Credit Research Foundation. (DSO is usually calculated by dividing a quarter’s accounts-receivable tally by sales for the period and then multiplying the quotient by the number of days in the quarter.)
But DSO scores don’t tell the whole story. Indeed, taken alone, the metric is probably one of the most misunderstood in corporate finance, notes Terry Callahan, the president of CRF. That could be a problem, because CFOs and credit managers closely track DSO. So do Wall Street analysts, investors, and auditors.
The confusion about DSO is that the metric in itself doesn’t provide the full picture of the collections process that it’s widely expected to provide. To be sure, DSO is a measure of the time and efficiency of collections and thus an indication of the success of a credit department. But it’s certainly not the only factor; other measures of a smooth-running credit department include customer service, sales incentives, and credit terms.
To make better use of the metric in assessing the success of credit departments, executives should compare DSO to another credit metric, the “average days delinquent” (ADD), Callahan suggests. When the DSO and ADD rise or fall in lock-step, it’s a safe bet that the collections process is driving the improvement or deterioration of the credit function.
But if the DSO drops when the ADD rises, “something odd is going on,” posits Callahan, and the dynamic deserves a closer look. That’s what happened in 2005. While DSO decreased, ADD rose to 7.5 days in 2005—a 1.5-day increase over 2004. The ADD score means that customers were late with their payments by an average of 7.5 days. Further, the increase in the score could mean that the collections process at U.S. companies is getting worse.
Last year wasn’t the first time DSO and ADD revealed a see-saw result. Over the past 10 years, it happened once before, between 1996 and 1997, when DSO dropped by 0.7 days and ADD rose by 1.3 days. Between 2000 and 1999, DSO dropped by 2.1 days, but ADD remained the same.
What an up/down relationship between DSO and ADD implies is that the DSO rise was probably not the result of more efficient collections. Instead, the increase was likely the result of shorter accounts-receivable cycles or tightening of credit terms, according to Callahan. Indeed, if the improved DSO was a function of better collection efficiency, then ADD would have risen accordingly.
Indeed, the discrepancy between the two measures can partly be ascribed to factors other than collection efficiency that contribute to a DSO improvement. For instance, improving customer service by eliminating confusion or disputes smoothes order processing and thus shortens the AR cycle. The AR cycle typically begins when a company invoices a customer for goods or services and ends with payment.
Reining in rogue salespeople that approve payment-term extensions for favorite customers is another way to tighten the AR cycle. Compliance with the Sarbanes-Oxley Act’s financial controls provisions and the general push for greater fiscal accountability have led many credit managers to stop lax salespeople from giving in to clients, according to Callahan.
Over the past few years, many companies have also tightened credit policies and procedures in response to corporate scandals, he says. Also contributing to the positive DSO trend has been improved technology, which enables credit and customer-service managers to do a better job of shortening the AR cycle, adds Callahan.
However, while finance executives need to take factors other than collection efficiency into account when analyzing their companies’ DSO numbers, the metric does provide significant insight into a company’s lost opportunity costs, contends Callahan.
In this context, lost opportunity cost means the lost use of funds resulting from the non-collection of receivables—even if customer payments aren’t past due. It’s the money owed to a business that it cannot put to use for such things as making capital improvements, buying inventory, or acquiring another company.
For the average CRF member company, one day of DSO amounts to a lost opportunity cost of $10,000 per day–or $3.65 million per year, Callahan estimates. (CRF, a non-profit group, comprises 4,000 credit managers from U.S.-based companies, ranging from Fortune 100 corporations to businesses with annual revenues of $250 million.)
To calculate the lost opportunity cost, Callahan divides the prime interest rate (which at the beginning of the year was 7.3 percent) by the number of days in the year (365), and then multiplies the quotient by the average month-end AR balance of a CRF company ($50 million).
Why does he include the prime rate in his calculation? Callahan says that if a company doesn’t generate enough cash flow from AR, it would have to borrow the money to buy inventory or equipment.
The point is that by reducing DSO by just a day, the average company generates $10,000 in cash flow. Thus, the standalone DSO metric is “more about cash flow,” than anything else, he says. And that’s certainly a worthwhile metric to track.