Management Accounting

The Trouble with DSO

Days sales outstanding is not a good metric for measuring collections performance, experts say.
Alix StuartJuly 28, 2011

Bandied about in earnings calls and the newspapers, days sales outstanding (DSO) is commonly used to describe how quickly a company is getting the cash it is owed into its coffers. But DSO doesn’t cover everything a finance chief might want to know about the credit department. Indeed, most people — including CFOs — don’t fully understand exactly what DSO is measuring, asserts Terry Callahan, president of the Credit Research Foundation (CRF).

The largest part of DSO is sales terms, says Callahan, a factor most credit managers can’t touch, he points out. “And if terms are 30 days, chances are DSO is never going to get below 30 days.” So, while DSO is a good measure of the revenue-to-cash cycle, it’s not a good measure of collections, he says.

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DSO is also easily manipulated, says Callahan. “Large increases in DSO can indicate a situation where a company is ‘forcing’ sales by accepting poor receivable terms, or selling its product at a discount to create sales for the period,” he charges.

Instead of DSO, the CRF recommends a different metric: the collection effectiveness index (CEI). This metric looks at collections relative to accounts that have come due and not the current receivables that are unlikely to be paid early. (See the box below for the CEI’s calculation.)

What CEI looks at, says Callahan, is “How much of what was collectible did we get?” One hundred is a perfect score, but the score could exceed that if a company asks customers for cash in advance.

On that measure, it seems companies are improving. According to the CRF’s latest quarterly survey, for the first quarter of 2011, CEI “shows a marked improvement over the last year, going from 80.72 to 85.20,” says Callahan.

While the concept isn’t used much yet in practice, CFOs would be wise to put DSO in such a context, says Veronica Heald, the customer-to-cash practice leader at REL, a working capital consulting firm. “Obviously DSO is never going to go away, because it’s what external investors use to determine whether or not the cash-flow position of a company is viable,” says Heald. But for management purposes, “I wouldn’t recommend using DSO in isolation,” she says.

Heald says that both CEI and “best-possible DSO,” a metric that assumes the company collects everything as it comes due, based on existing sales terms, could be useful to finance executives, but neither is common right now. CEI, in particular, could be calculated for each collections employee, as well as for each customer. “Instead of looking at good, average, and poor payment behavior, you could use CEI scores to segment customers, and then focus your collections efforts on the customers with the lowest scores,” she says.

Rob Olsen, chief lending officer for Marlin Bank and a CRF member, says he has used CEI for nearly 30 years in past roles that put him in charge of collections for receivables such as payments on corporate credit cards. “Using the CEI makes it fair as to how you reward collectors for their efforts, because it removes the sales bias,” he says.

Olsen has written a number of papers and given seminars on the benefits of the measure, which is easily calculated. He doesn’t expect it to make the headlines anytime soon, though. “There are plenty of organizations calculating it and using it within their department, but it’s not being disseminated companywide,” he says. “CFOs tend to say, ‘Just give me DSO,’ and if the boss doesn’t care, collection managers aren’t going to report it.”