Accounts receivable collection period | Days sales outstanding
/What is the Accounts Receivable Collection Period?
The accounts receivable collection period compares the outstanding receivables of a business to its total sales. This comparison is used to evaluate how long customers are taking to pay the seller. A low figure is considered best, since it means that a business is locking up less of its funds in accounts receivable, and so can use the funds for other purposes. Also, when receivables remain unpaid for a reduced period of time, there is less risk of payment default by customers.
What is Days Sales Outstanding?
Days sales outstanding is most useful when compared to the standard number of days that customers are allowed before payment is due. Thus, a DSO figure of 40 days might initially appear excellent, until you realize that the standard payment terms are only five days. DSO can also be compared to the industry standard, or to the average DSO for the top performers in the industry, to judge collection performance.
A combination of prudent credit granting and robust collections activity is indicated when the DSO figure is only a few days longer than the standard payment terms. From a management perspective, it is easiest to spot collection problems at a gross level by tracking DSO on a trend line, and watching for a sudden spike in the measurement in comparison to what was reported in prior periods.
To calculate DSO, divide 365 days into the amount of annual credit sales to arrive at credit sales per day, and then divide this figure into the average accounts receivable for the measurement period. Thus, the formula is:
Average accounts receivable ÷ (Annual sales ÷ 365 days)
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Example of Days Sales Outstanding
The controller of Oberlin Acoustics, maker of the famous Rhino brand of electric guitars, wants to derive the days sales outstanding for the company for the April reporting period. In April, the beginning and ending accounts receivable balances were $420,000 and $540,000 respectively. The total credit sales for the 12 months ended April 30 were $4,000,000. The controller derives the following DSO calculation from this information:
(($420,000 Beginning receivables + $540,000 Ending receivables) ÷ 2)
÷ ($4,000,000 Credit sales ÷ 365 Days)
=
$480,000 Average accounts receivable
÷ $10,959 Credit sales per day
= 43.8 Days
Why the Collection Period is Important
The accounts receivable collection period is an essential measure for a business, since it shows the amount of time during which company cash is tied up in the hands of customers. Management should be constantly striving to reduce the collection period, thereby returning cash to the business. If it does not do so, then management must find other sources of cash to keep the business operating, such as by selling shares to investors or obtaining more debt from lenders - which may not be palatable options.
Furthermore, a shorter collection period results in more cash being available for other purposes within the business, such as investing in new product development, hiring more customer service staff, or acquiring new store locations - all of which can increase sales, which in turn generates even more cash to fund further growth.
Problems with Days Sales Outstanding
The correlation between the annual sales figure used in the calculation and the average accounts receivable figure may not be close, resulting in a misleading DSO number. For example, if a company has seasonal sales, the average receivable figure may be unusually high or low on the measurement date, depending on where the company is in its season billings. Thus, if receivables are unusually low when the measurement is taken, the DSO days will appear unusually low, and vice versa if the receivables are unusually high. There are two ways to eliminate this problem. First, generate an average accounts receivable figure that spans the entire, full-year measurement period. Second, adopt a rolling quarterly DSO calculation, so that sales for the past three months are compared to average receivables for the past three months. This approach is most useful when sales are highly variable throughout the year.
Whatever measurement methodology is adopted for DSO, be sure to use it consistently from period to period, so that the results will be comparable on a trend line.