Making B2B sales on credit with net payment terms raises several questions:
- What are the net payment terms on the invoice?
- Do all trading partners pay with the same net terms?
- Do some pay early? Do some pay late?
- Are you worried you’ll need to chase some late payments?
- How can you determine the average waiting time for outstanding balances?
- Is it possible to use that information to improve your invoicing processes?
Days Sales Outstanding (DSO) is a useful accounting metric that helps deal with these types of questions. DSO gives you an indication of your invoice collection speed and health.
In other words, DSO tells you how long you have to wait to get paid for products already delivered or services already provided.
This article explores DSO, including:
- DSO definition
- Some advantages of tracking DSO
- What’s a good or bad DSO?
- Factors that influence DSO
- DSO calculation
- DSO reduction strategies for SMEs
- How B2B Buy Now, Pay Later solutions provide multiple payment options and speed up receipt of payment
What is Days Sales Outstanding (DSO)?
DSO definition: DSO indicates the average amount of time it takes for your company to collect money after invoicing. That means it’s the average amount of time to change accounts receivable into cash in your treasury. Basically, DSO shows the average time your business partners wait before paying you.
General rule = higher DSO, bad; lower DSO, good.
What are accounts receivable?
Let’s backtrack and define accounts receivable. Accounts receivable are the invoices you have sent, but your customers have not yet paid, i.e. unpaid invoices. Accounts receivable are considered assets on your balance sheet. They affect your company’s cash flow because you wait to collect the money.
What does DSO measure?
DSO measures the average number of days against a period of time, e.g. a month, a quarter, or a year. 42 days in quarter 2 means it took an average of 42 days for customers to pay invoices in Q2.
We will examine how to calculate DSO a bit later in this article. One thing to bear in mind, DSO is an average so it’s not a perfect KPI. Your overall result doesn’t tell you about one particular trading partner.
However, Days Sales Outstanding is a great health check. You get an indication of how payments are trending and helps you forecast in the medium term. Smaller average DSO indicates that a company is collecting payments quickly, improving cash flow, and has overall financial health.
With some creativity you can use it to better manage cash flow and even examine regular trading partners.
Tracking Days Sales Outstanding provides advantages
Tracking DSO provides several advantages beyond having the metric itself. Use what you learn from it to improve your company’s operations, e.g. invoicing processes.
First, it has the knock on effect of staying on top of invoice collection. So it helps your company function efficiently.
Second, forecasting your cash flow or working capital is a real advantage. The time it takes to convert expected money into real money becomes predictable. This predictability enables more accurate planning.
Next, think about what trends exist with your customers’ payment habits. Exploit DSO to let you compare your invoice collection success over time. Knowing the trends or spotting aberrations from previous years further helps planning and making adjustments to plans.
What’s a good Days Sales Outstanding (DSO) or bad one?
You have more cash flow and working capital the faster you collect payments from invoices. What does a high or low DSO mean? Your company takes a long time to collect owed payments.
On the other hand, a low DSO shows your customers are paying on average in a shorter period of time. An average DSO of 45 and below is considered a ‘good’ while a higher DSO may be considered as ‘bad’.
Be reasonable
That seems logical, but there may be more to the story. DSO is a guide toward gauging the risks or health involved with payment terms. Common sense is useful. For example, if you set a target to improve your DSO to 60 but the payment terms you agree with most of your customers is 90 days, then the target isn’t reasonable.
There is a certain relativity to DSO both imposed by your own company’s expectations, and by external factors.
How to calculate Days Sales Outstanding (DSO)
Let’s start understanding Days Sales Outstanding with the basic calculation.
First, if you bring in some immediate cash payments, just ignore those. DSO is only concerned with the money you still need to collect, so sales on credit, i.e. sales with net terms in the invoice or accounts receivable balance.
The Days Sales Outstanding formula includes total accounts receivables, total credit sales and the number of day in your defined period. DSO is calculated according to this formula:
(accounts receivable / total credit sales) x number of days in the target period = DSO
DSO calculation example
Let’s define the period we want to focus on. In this case let’s use one quarter, or 90 days. Then, let’s look at the all the credit sales in that period, which is €4,200,000 in our example.
Now, let’s look at what has already been paid. Let’s say that is €1,500,000 euros. That means our accounts receivable (i.e. unpaid invoices) total €2,700,000.
Our Days Sales Outstanding is 58 days (rounded up from 57.86). Using the formula above, we calculate DSO like this:
(2,700,000 / 4,200,000) x 90 = 57.86 days
Activating the DSO formula to improve cash collection
The main takeaway: one annual basis calculation won’t help that much. Instead, you should work out a system that allows you to compare DSOs.
When you compare various results you start to discover trends about your invoice collection health and cash management and your payment process.
We suggest numerous parameters that lead to actionable insights:
- Year on year: quarter to quarter (e.g. Q2 2023 vs Q2 2022) or month to month (e.g. April 2023 vs April 2023)
- Year on year; or multiples years on multiple years: annualised (e.g. 2022 + 2021 vs 2020 + 2019)
- Particular quarter vs previous quarter (e.g. Q2 2023 vs Q1 2023)
- Particular quarter vs previous X quarters (e.g. eQ2 2023 vs Q1 2023 + Q4 2022)
- Particular month vs previous month (e.g. April 2023 vs March 2023)
- Particular month vs previous X months (e.g. April 2023 vs March + Feb 2023)
What influences Days Sales Outstanding (DSO)?
Several influential factors affect your average collection time:
- How robust are your business partners?
- DSO vs DPO
- EU and UK payments rules
- Which way is the wind blowing?
- What payment options are there?
- What levels of trust do you have with your business partners?
- Which industries are you working with?
How robust are your business partners?
Did you know that your DSO is influenced by how financially robust your partners are? The more financially stable and strong your customers are, the more likely they will pay on time.
There is also a domino effect to lower DSO across the board. 67% of UK companies surveyed in 2022 say the faster a company receives payment, the faster they pay their own suppliers in a timely manner.
41% of European companies say their company’s growth is prohibited by late paying customers while 26% say receiving payments late threatens their survival!
DSO vs DPO
DPO is Days Payable Outstanding. DPO shows the average time a company takes to pay its bills. Meaning, choosing the right partners reduces DSO.
Ideally, you have a positive DSO to DPO ratio that increases your cash flow, i.e. you collect cash faster than you make your own payments.
The EU and UK’s payment rules
Both the EU and the UK have been making legislative moves to push larger corporations to pay smaller ones more rapidly. Let’s briefly the main pieces of legislation:
- The EU’s Late Payment Directive
- The UK’s Prompt Payment Code
EU Late Payments Directive
The EU’s Late Payments Directive aims to support businesses by increasing the speed of payments. It clearly defines sanctions for not meeting targets. It acts as a minimum standard affecting both enterprises and public authorities.
The LPD has five main provisions:
- public authorities – must pay within 30 days (60 days in special circumstances)
- enterprises – must pay within 60 days (this can be longer if agreed between the trading partners)
- late payment penalty – interest with a minimum of €40 to compensate recovery costs
- interest rate – at least 8% above the European Central Bank’s reference rate
- country discretion – EU countries may go above and beyond these minimums by creating rules that are more favourable creditors
Even with the LPD, paying late of course continues. Serious consequences result: one in four bankruptcies in the EU is caused by late payments. So, the EU is taking more action. 2023’s EU Work commission established a revision of the LPD as one of the 43 new policy initiatives.
Keep your eyes pealed on the European Commission’s new proposal for a new Late Payments Regulation. We’ve made a summary of the EC’s FAQs on the new Regulation.
UK Prompt Payment Code
The UK recently provided some great news for SMEs. Large corporations have been instructed to increase payment speed to small businesses with less than 50 employees. Now the 2800 signatories of the UK’s Prompt Payment Code (PPC) must pay small companies in 60 days (government bodies must pay in 30 days). The end of 2022 saw the UK reviewing the effectiveness and exploring ways to further enforce compliance.
Tailwinds, headwinds, and DSO value
When companies are operating into a headwind, i.e. challenging economic times, they may slow down their payments schedule. But, the opposite can also occur: with a tailwind, i.e. in good times, some businesses may pay more rapidly.
Seasonal and temporal factors are likely to influence your DSO. Covid-19 illustrates this point clearly.
Atradius [1] research shows that in 2020:
- 37% of Western European businesses reported their DSO increased by +10%
- 57% reported a 0 to 10% increase
- 7% reported a lower DSO.
Bear in mind, a 10% increase on 60-day net payment terms is basically an additional week before cash collection. Brutal for an SME trying to manage cash flow and survive!
Identifying customers and trust
Trust relationships that exists between businesses can reduce or raise a company’s Days Sales Outstanding. Imagine your customer is a trusted company because they’ve been your business partner for a long time and always pay on time. The customer credit risk in this case is low.
Here, you have solid evidence-based reasons to lengthen their payment time. Their strong track record means you can increase flexiblity. This may result in a higher DSO for you, but it’s a strategic increase you have chosen because it increases customer satisfaction.
If you know your customer and have established trust, you may also know they could use a grace period for outstanding invoices. Although you get paid after the expected time, your generosity yields mutually beneficial results, i.e. increasing Customer Lifetime Value (CLV), the real prize!
Also consider providing early payment discounts.
Industries influence DSO value
Acceptable DSO ranges vary from industry to industry. You just need to be aware of which industries are slower and which are faster. Knowledge of an industry’s average DSO lets you plan accordingly.
The real cash effect of reducing DSO
The lower the company’s DSO, the higher the cash flow.
Using our example DSO calculation from above, we had 57.68 average number of days waiting for payment. It takes over 8 weeks on average for you to receive payments owed.
Let’s imagine you are able to lower that by about 10 days. In this case that would mean increasing cash flow by approximately €500,000 during that designated 90-day period.
That’s half a million in your treasury in less than 7 weeks instead of more than 8 weeks. Or, an extra 50k per day that you lower your DSO.
How small businesses can improve their Days Sales Outstanding (DSO)
SMEs have good reason to reduce DSO. Do SMEs have the fallback of vast resources like large corporations? Not usually!
If the company’s DSO shortens, i.e. bring in payments more quickly, the company will have healthier cash flow and operate more flexibly and efficiently. So, DSO reduction strategies are useful.
Analyse customer payment history
Your overall DSO is not targeted at any specific trading partner, but what’s preventing you from breaking down your DSO by customer?
Doing an in-depth analysis for each customer informs you of your cash collection waiting period and may improve your cash conversion cycle. Compare those to your internal averages and industry benchmarks. Take suitable steps if you observe actionable insights.
Clear and timely communication
Are payment terms unchangeable over time? No way! Build trust by communicating with your customers. By consulting with companies more payment options get on the table. You might be able to agree on decreasing payment terms for future purchases.
That can be a soft target – even if you know they won’t meet the agreed shorter terms, it might help to speed up the payment process.
Another idea is to use a system that sends automated payment reminders sequenced before (and after) due date.
Carrot and stick – offer incentives and demand late fees
Imagine the standard payment term is 60 days. Add early payment discounts to payments made in less than 45 days. This motivates your customers to pay earlier if they can. Ensure your customers know about this in advance through clear communications!
In tandem with early payment discounts, make sure you have a clear late fees policy encouraging customers to pay in a timely manner and reduce debt collection.
Meanwhile, you’ll need a strong debt collection process as backup! Worst case scenario? You may need to purge a customer.
Apply the principle of timeliness to your collection process
Why wait? Reduce cash flow problems by sending invoices as soon as you’ve delivered the service or shipped your product. Implement invoicing policies and collection processes that gives you the best chance to get paid most efficiently and prompt DSO reduction.
Timely billing through fast invoicing allows customers to pay ASAP.
How to improve DSO and a company’s cash flow with BNPL
Give your customers different payment methods. But, extending credit can be challenging for SMEs. Buy Now, Pay Later (BNPL) is an up-to-date, digital deferred payments solution. SMEs in any industry can offer BNPL to reduce DSO. We should call it Sell Now, Cash Now from the perspective of the seller!
Terms.Tech improves customer satisfaction by extending credit when a merchant or marketplace cannot. And, making timely payments to solve cash flow problems.
How does BNPL for B2B work? At an e-shop or customer payment portal’s checkout, Terms.Tech provides multiple payment options (e.g. 30 / 60 / 90 days). The buyer chooses, e.g. payment terms of 60 days. Traditionally that means the seller would receive the money two months after shipping. With Terms.Tech, however, the seller is paid upfront and thus reduces DSO.
But what about payment collection issues? For the seller, it doesn’t matter – already been paid! Terms.Tech is responsible for collecting payment from the buyer and debt collection.
How does a BNPL service affect your DSO?
Down! Reduce DSO as each customer chooses to use Terms.Tech. That goes for current customers as well as new customers. Your cash flow improves along the way.
🤝 Get in touch with our Terms.Tech expert sales team. Discover the best BNPL solution for you.
More on benefits of offering a B2B BNPL solution here.
Sources since unpublished:
[1] – Atradius Payment Practices Barometer Western Europe 2020
