Managing Accounts Receivable Effectively
How Does My DSO Affect Cash Flow and Working Capital?
By Stan Prokop
Most business owners and financial managers know the importance of managing accounts receivable effectively. The method by which the largest corporations in the world, and a small company measure collection activity, is called DSO, or ‘Collection Period’. DSO stands for DAILY SALES OUTSTANDING.
Business owners can calculate this number very quickly, and we recommend it be done regularly, typically monthly, quarterly, and certainly annually. It’s a great business measurement of your success, and lenders also focus in on this number also.
Learning how to manage accounts receivable is a must for all businesses, but in particular the small business.
How is the DSO calculated? It’s an easy calculation, as follows:
Accounts receivable / average daily credit sales
The answer is expressed in days – e.g. ‘Our DSO is 40 days ‘
Again, we emphasize this is the traditional measure of success in monitoring a company’s investment in accounts receivable. In our above example we said the DSO number was 40 days. So what? Is that good or bad. Well, we benchmark against our selling terms. A great portion of industry revolves around payment terms to customers of 30 days. (We can hear most business owners saying ‘I wish…”!) If our customers, on average are paying us in 40 days, and our terms are 30 days, you can see there is a ten day additional carrying of accounts receivable. so, managing accounts receivable effectively can mean a different thing to different companies and/or industries.
So the bottom line is that the longer the DSO the more focus management has to pay on account receivable collections. Business owners know all too well bills and employees are paid with cash, not profit!
In most businesses as sales go up many financial controls go down. That’s unfortunate of course, but the fact is that many firms that have explosive sales growth tend to de-focus on DSO, as that measure is masked by sales growth and profit. Management and sales personnel are often favoring loosening credit standards to meet revenue and profit goals.
We point out that the DSO calculation is a reflection of one point in time – that’s why it is important to monitor the overall trend of DSO on a longer term basis. Naturally all good businesses age their receivables, so they know how old they are and focus on past due accounts. When a company selling on 30 day terms has a significant investment in 60 and 90 day receivables we can very accurately predict that DSO quality is declining.
Naturally in difficult and recessionary times everyone must know how to manage receivables and is holding onto cash longer, and only management can focus on specific actions such as improving collections.
The importance of accounts receivable management cannot be overstated!
Focus on DSO improves working capital and overall business cash flow – so it’s a valuable asset in any owners ‘financial toolkit ‘to working capital improvement.
Stan Prokop is the founder of 7 Park Avenue FInancial.
The company originates business financing for Canadian companies and is a specialist in working capital and asset based financing of all types. For more information or contact details please see: http://www.7parkavenuefinancial.com/Home_page.html
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