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 to collect payments?
- 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 will explore DSO, including:
- DSO definition
- Some advantages of tracking DSO
- What’s a good or bad DSO?
- Factors that influence DSO
- DSO calculation
- How SMEs can improve their DSO
- How B2B buy now, pay later solutions can speed up receipt of payment
What is DSO?
Let’s start with a 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.
DSO is used to measure 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 and your overall result doesn’t tell you about one particular trading partner.
However, Days Sales Outstanding is a great health check. It gives you an indication of how payments are trending over time and helps you forecast in the medium term. And, 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. You can use what you learn from it to improve your company’s operations.
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. You can 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 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. 45 and below is considered a ‘good’ DSO while a high DSO may be considered as ‘bad’.
Do we always want a low DSO? Although that seems logical, there may be more to the story. Bear in mind that 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.
What factors can influence DSO?
There are several influential factors that 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 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? What do we mean by that? 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 can pay their own suppliers. 41% of European companies say that their company’s growth is prohibited by late payments while 26% say late payments threaten their survival!
DSO vs DPO
DPO is Days Payments Outstanding, and shows the average time a company takes to pay its bills. Meaning, choosing the right partners helps your DSO. Ideally, you have a positive DSO to DPO ratio, meaning you are bringing in cash faster than you are paying it out.
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
The EU’s Late Payments Directive
The EU’s Late Payments Directive aims to support businesses by increasing the speed of payments. It also clearly defines sanctions for not meeting the targets. It affects both enterprises and public authorities and acts as a minimum standard.
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 LDP, late payments of course have continued. And with serious consequences: one in four bankruptcies in the EU is caused by late payments. So, the EU is taking more action. SME relief in 2023’s EU Work commission establishes a revision of the late payments directive as one of the 43 new policy initiatives. From January to March 2023 the EU held a call for evidence and intends to release the newest revision of the LPD by summer 2023.
UPDATE, October 2023: 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.
The UK’s Prompt Payment Code
The UK has recently provided some great news for SMEs. Large corporations have been instructed to increase the speed of their payments to small businesses with less than 50 employees. Now the 2800 signatories of the UK’s Prompt Payment Code (PPC) must pay B2B transactions to small companies in 60 days (and government bodies must pay in 30 days). The end of 2022 saw the UK reviewing the effectiveness and exploring ways to further enforce compliance.
Which way is the wind blowing?
Let’s think about tailwinds and headwinds. 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 research shows that in 2020:
- 37% of Western European businesses said that their DSO increased by more 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 receiving payment. That can be brutal to an SME trying to manage cash flow and survive!
What level of trust do you have with your business partners?
The trust relationship that exists between businesses can improve or damage a DSO. Imagine your customer is a trusted company. For instance, they’ve been your business partner for a long time and always pay on time. In this case you may have solid evidence-based reasons to lengthen the payment time. Their strong track record may mean you are more flexible. This may result in an increased DSO for you, but it’s an increase you have strategically chosen to be palatable.
Again, if you know your customer and have established trust, you may also know they could use a grace period to deliver a payment. Although you get paid later than expected this time, your generosity will be mutually beneficial in the long-run. This may increase Customer Lifetime Value (CLV), the real prize!
Which industries are you working with?
Acceptable DSO ranges vary from industry to industry. You just need to be aware of which industries are slower while other industries are faster. And, this knowledge lets you plan accordingly.
How to calculate Days Sales Outstanding
Let’s dig in on how to find your DSO. If you’re bringing 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.
The Days Sales Outstanding formula is pretty straightforward. It includes total accounts receivables, total credit sales and the number of day in your defined period, like this:
(accounts receivable/total credit sales) x number of days in the target period = DSO
An example DSO calculation
Let’s define the period we want to focus on, in this case let’s say it’s one quarter, or 90 days. Then, let’s look at the total credit sales in that period, which in our example will equal €4,200,000. Now, let’s look at what has already been paid, and let’s say that is €1,500,000 euros. That means our accounts receivable is €2,700,000.
So, for this example, our Days Sales Outstanding is approximately 58 days (rounded up from 57.86). Using the formula above, the DSO is calculated like this:
(2,700,000 / 4,200,000) x 90 = 57.86 days
How can we activate the DSO formula to work for us?
The main takeaway is this: one calculation won’t help you very much and 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. Here are a handful of ways to make comparisons that can lead to actionable insights:
- Year on year: quarter to quarter (e.g. Q2 2023 vs Q2 2022)
- Year on year: 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)
The real cash effect of a lower DSO
What is the real cash flow effect of a lower Days Sales Outstanding? The lower the DSO, the higher the cash flow. Let’s take a look.
Using our example DSO calculation from above, we had a DSO of 57.68 days. That means 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 approximately €500,000 higher cash flow 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
Small and medium-sized enterprises (SMEs) have good reason to want to lower their days sales outstanding. Do SMEs have the fallback of vast resources like large corporations? No! (Well, at least not usually.) So, if an SME can shorten its DSO, i.e. bring in payments more quickly, the company should have a healthier cash flow and be able to operate more flexibly and more efficiently.
Customers – analyse each one to spot insights
Although your overall DSO is not targeted at any specific trading partner, what’s to stop you from breaking down your DSO by customer? Carrying out a more in-depth analysis for each customer will inform you about each customer’s behaviour in the overall context of your collection waiting period. Compare those to your internal averages and also with industry trends and averages. Take suitable steps if you observe actionable insights.
Sharing is caring – make sure communication is clear and timely!
Are payment terms unchangeable over time? No way! Build trust by communicating with your customers.By consulting with companies you might be able to agree on decreasing payment terms for future purchases. This can be a soft target, like a push. Even if you know they probably won’t meet any agreed shorter terms, they might help to speed up payments compared to slower past payments.
Carrot and stick – incentives and late fees
For example, imagine the payment term is 60 days. Well, just add a small discount to payments made in less than 45 days. This encourages your customers to pay earlier if they can. And, make sure your customers know about this in advance! Make sure you also have a clear late fees policy. In worst case scenarios you may need to purge a customer.
Apply the principle of timeliness
Why wait to invoice? Send those invoices as soon as you’ve delivered the service or shipped your product. Form policies and procedures for your invoicing that gives you the best chance to get paid most efficiently.
And, there’s also the option to integrate buy now, pay later into your B2B payment options.
How to improve your Days Sales Outstanding with buy now, pay later
Buy now, pay later (BNPL) is an up-to-date, digital deferred payments solution. And, SMEs in any industry can use BNPL to improve their DSO. Maybe we should call it Sell Now, Cash Now from the perspective of the seller! Terms.Tech works to provide BNPL services to B2B transaction needs – whether you’ve got a sleek B2B marketplace or conducting buying and selling offline.
How does BNPL for B2B work? At checkout, a buyer can choose to pay with payment terms, e.g. 60 days. Traditionally that means the seller would receive the money long after delivering the goods or service. But, with a BNPL service the supplier receives payment much earlier. With Terms.Tech, the seller is paid upon proof of delivery. But what about late payments and payment collection issues? For the seller, it doesn’t matter – already been paid! Terms.Tech, however, agrees to be responsible for dealing with and collecting on late payments from the buyer.
How does a BNPL service like Terms.Tech affect your DSO? Down. Down. Down. Your DSO lowers with each customer who chooses to use Terms.Tech, and your cash flow improves along the way.
🤝 Why wait to find out more? Get in touch with our Terms.tech consultants and see what the best BNPL solution is for you.
Read more about the benefits of using a BNPL for B2B solution here.
