How Reducing Your DSO Can Solve Cash Flow Woes
DSO measures the time it takes to receive revenue. A low DSO indicates prompt payments, and a high DSO suggests payment delays. Understanding DSO and comparing it to industry benchmarks is vital for financial decisions.
DSO averages the time it takes for your company to receive revenue. A low DSO means that, in general, your customers quickly make their payments. Conversely, high DSO means that customers tend to delay payments. High or rising DSO values can indicate issues in your accounts receivable process that you need to address.
Many companies struggle with the problem of getting customers to pay invoices on time. On-time payments are critical to a business's cash flow. Since understanding the details of customer payments is the first step towards improving cash flow, many companies keep track of Days Sales Outstanding (DSO).
Why You Should Care About Reducing Your DSO
You know what DSO means, technically. But how important is it?
The short answer: Very.
Understanding what DSO is, where your company's DSO is currently, and where your DSO should be are all critical metrics used to make informed financial decisions.
Many CFOs and accounting professionals start setting goals by matching the company's DSO to the industry benchmarks. For example, some measure success by measuring the average Days Sales Outstanding. According to a study by Euler Hermes, the average DSO for businesses worldwide tends to be around 65 days.
But comparing your business's DSO to this average won't be helpful. Many other factors need to be taken into account.
What Factors Affect Your DSO
Just looking at an average number isn't very helpful. DSO numbers can span a wide range over different industries. To understand your DSO, you'll need to compare it to other companies in your industry.
For example, if your industry has a low DSO on average, 65 days might not be a good score. Consider trying to reduce your DSO to match other companies of similar size. However, a DSO of 90 days might not be as bad as it looks if you're in an industry where a higher DSO is common. In that case, spending time and energy on reducing Days Sales Outstanding may not be worth it.
If your company experiences seasonal fluctuations, you'll want to take that into account as well. Your DSO value in June could completely differ from your DSO value in December. It may be a good idea to factor your DSO based on a quarterly or yearly period to account for these changes. This will yield a more accurate DSO.
Use This Simple DSO Calculation
You'll need to find your company's DSO. Start by deciding on a reporting period. A monthly period is usually a good option. Then, find your accounts receivable balance for your chosen period and divide that number by total credit sales. Finally, multiply your answer by the number of days. This value is your DSO.
(AR balance for a chosen period / Number of total credit sales)
Number of days for the chosen period
Once you note your DSO, you can determine whether it's good or bad.
What High or Low DSO Values Mean
Now that you've benchmarked where your business' DSO ought to be and calculated your company's specific DSO, it's time to compare it to the competition. If you have a comparatively low DSO, your customers diligently pay on time, and your business should have good cash flow. A lower DSO is generally considered a "good DSO." Trying to reduce your DSO probably isn't worth your time.
However, if your DSO is higher than average, you'll want to consider taking serious steps to change it.
Disadvantages of a High DSO
A high DSO, or, even worse, a steadily rising DSO, means that your customers are slow about paying outstanding invoices. Doing nothing about a high DSO can result in poor cash flow, lousy customer habits, and inefficiency.
Cash flow is essential to running a successful business. When customers delay payments, your working capital is compromised. That, in turn, makes business improvements and growth difficult or impossible. As a result, these overdue payments ultimately hinder the success of a business.
If you don't do anything to reduce a high DSO, customers will start thinking that late payments are acceptable. They may even begin to ignore a payment reminder. Or they won't pay at all. At the same time, accounts receivables teams will struggle to capture overdue payments. And this delay slows down and, in some cases, confuses the cash application process.
Improving your DSO is a simple way to increase your business's chance of success. And the good news is that several options are available to help you.
7 Ways to Reduce DSO
Now that you know where your DSO is and where you want it to be, it's time to start taking some serious steps toward reducing your DSO. Improvement is possible in many areas, whether you clear up communication, offer incentives, or automate invoices.
Here are seven effective ways to improve company DSO:
1. Automating Invoices
The faster customers receive their invoices, the less time they will take to pay. As a result, automating your billing processes can be a very effective way to reduce DSO.
Automation saves time on both ends. On the business side, invoices can simply be sent out more quickly. But automation also eliminates the possibility of human error, meaning that customers receive accurate, clear, and concise invoices. Better communication through automation often reduces delays due to customer confusion. And for B2B payments, it will make your customer's accounts payable team happy. In fact, according to one study, 75% of firms with automated AR processes said that it provides a superior customer experience.
Automation can also help with properly complying with customer invoice requirements. Customers often use order numbers when purchasing items, so invoices may get lost if they don't match up with valid order numbers. Be sure to obtain plenty of information about customer preferences for invoices, such as how invoices should be delivered, preferred contact information, and when payments are generally made. If invoices are consistent and regular, mistakes and delays are less likely to occur, which will, in turn, reduce DSO.
2. Editing and Communicating Payment Terms
It may be a good idea to rethink your payment terms. It becomes the accepted norm when you allow customers to wait weeks to pay. Consider using a shorter payment term, such as a Net-14, instead of a Net-30. You may lose some customers, but it could save your company time and money in the long run.
It's also important to remember that customers can have legitimate reasons for paying late, and confusion can be considerable. If customers often call customer service with questions about payment terms, ensure that your terms make sense. Having clear, simple payment terms that customers can access easily and understand is a simple way to reduce customer confusion. And prevent a high DSO.
If your invoicing software allows it, try including your payment terms in every invoice. That way, information is readily available for customers to reference as they complete the payment process.
3. Sending Reminders
It's often easy to forget about payments or even misplace the invoice. A high DSO doesn't mean customers intentionally procrastinate about paying up on accounts receivable. It could be simple, honest forgetfulness, which you can help fix.
Friendly reminders can keep customers accountable and up to date on payment status. These should be sent out regularly after the initial invoice. They can contain information about the payment process, terms, relevant deadlines, and rewards for early payments.
Following up on an overdue invoice can be done in various ways, such as emailing, texting, and calling. It might be a good idea to use multiple options, as different customers may prefer other modes of communication.
Making it easier to pay, from the invoice or the follow-up communication, can also speed up customer payments. When you use a service such as Paystand, you can easily embed a "pay now" button on every invoice and reminder.
4. Offering Incentives
Offering rewards can incentivize early payments. For example, you could offer discounts to customers who pay within ten days or provide sneak peeks at new services or products for customers who consistently pay early.
At the same time, make sure there are also consequences for paying late. If customers aren't penalized in any way for late payments, there's no reason to make an effort to pay on time.
5. Providing Different Payment Options
Digitizing your payment process by offering digital payment options makes things easier for the company and customers. Since paying online takes very little time, customers don't need to carve out hours to figure out a complicated paper billing system. As a result, making payments is much faster and easier, encouraging customers to submit payments promptly.
Not all customers will opt for this, so offer another payment option. Consider accepting electronic payments, credit cards, ACH, and paper checks so customers can choose the most convenient payment method. When customers don't have to figure out a payment method they are unfamiliar with or unused to, you'll find fewer and fewer overdue payments.
Businesses can also steer customers toward low-cost payment options. For example, Paystand's bank-to-bank network is free, which can motivate usage, especially if credit card payments carry a convenience fee to cover transaction costs.
6. Dealing With Late Payments
Sometimes customers miss deadlines or don't pay at all. While this is annoying and often time-consuming to resolve, having a clear plan for what to do in these situations is critical.
We can all be forgetful sometimes, so start with friendly invoice reminders to help maintain a good relationship with your customer. If the delay were unintentional, your customer would pay immediately. Remember that convenient, varied payment options with embedded "pay now" buttons in all communications can make the request easy to fulfill.
However, if multiple reminders don't receive a response, you should consider walking away from the customer. Getting rid of potential business is always challenging, but if customers are regularly late on payments, they might not be worth the trouble.
7. Evaluating New Customers
Customers are an integral part of any business. As a result, you should carefully consider them and consider whether they're the type of clients you want to keep.
Removing problems before they begin will save you a lot of trouble later. Assessing customers includes running credit reports and checking customer websites for poor reviews. This should help weed out the most problematic customers before they cause trouble.
Being too selective, however, is impossible for your particular company, but you should set some parameters for new customers. Then you can determine the minimum acceptable credit risk and accept potential customers based on it.
Looking to learn more ways to improve your cash flow and simplify your AR process? Check out our article on 5 easy ways to reduce your DSO.