There is always huge debate in Credit Management circles on the validity of DSO as a measure of the effectiveness of the Credit department. Some swear by it as the only measure and others rubbish it as a wrong way of measuring success.
I believe in somewhere in the middle, I think it is a valid measure if it is calculated correctly but should not be the only measure of the success of an entire Credit function. The job is certainly about collecting money and that is important, what is more important is keeping your customers happy and buying. It is also important to be making correct commercial decisions on the amount and duration of the credit you extend, it is important to have your paperwork correct. None of these factors will be tracked by using DSO alone as your measure. The one thing I have discovered is that you have to be very careful about how you measure success because what you report on becomes the driver that creates the performance and not the other way around.
How you will know you are not calculating your DSO’s correctly is if an increase in sales in the current month affects the number – your DSO figure should only be influenced by the collection activity.
Like any figure there are a number of ways it can be calculated, I’ll go through the main ones here:
1. Take your annual sales and divide the number by 365. This will give the value of a single day’s sale. Then divide your debtors by the value of a single days sale will give you a DSO figure. This is a crude method of calculation and does not take into account swings in sales or collection that can happen at year end. This method works when comparing figures year on year to see the trends within a business and while I would recommend you using this from a risk assessment perspective I wouldn’t recommend it as an accurate monthly measure of your performance.
2. You can use a quarterly version of the above, taking your quarterly sales dividing them by 90 to get a single day and use the same formula as above. It has the same drawbacks as the annual method.
3. For a monthly calculation I recommend the count back method of calculating your DSO’s this removes any bias for extremely high or low sales in the current month and reflects more accurately the collection effectiveness – it is calculated as follows:
You take the balance on your debtor’s ledger and subtract the current months gross sales including VAT and keep going back each month until the remainder gets to zero as follows:
Ledger balance is €30,000
September Gross Sales were €12,000 – there are 30 days in September
The balance remaining is €18,000
August gross sales were €11,000 – there are 31 days in August
The balance remaining is € 7,000
July gross sales were €14,000 – there are 31 days in July
From the above figures the €30k balance represents all of September sales(=30 days), all of august sales (=31 days) and half July sales (= 15.5 days) So the DSO for this company for September is 30+31+15.5 which is 76.5 days. The beauty of this method is that if the sales guys had a bumper month and sold €24k – the ledger balance would increase to €42k – using the calculation above it would still come out at 76.5 days.
Then every month you can track your progress as long as you get accurate gross sales figures, treat your cash sales consistently and make sure you have the same cut off point every month. If you hate all the sums and want a simple calculator in spreadsheet format that will do the sums for you drop me an email to firstname.lastname@example.org and I’ll gladly send it to you for free.