finance chiefs and credit managers routinely consult
"days sales outstanding" numbers to judge how
efficient their companies' collection operations are, DSO
tells only part of the story.
metric known as "days sales outstanding" (DSO), a
gauge of credit-collection efficiency, is at a 10-year low for
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.
2005, the average DSO for
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.)
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.
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.
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.
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
companies is getting worse.
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.
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
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
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
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
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).
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.
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.
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
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
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.