In the wake of widespread recession fears, high interest rates and peak inflation, many large, U.S.-based organizations now view hoarding cash as prudent practice. For companies that do business with these large firms, that often means waiting longer to get paid.
These shifts in payment culture are not unique to big business, either.
Finance managers are increasingly vexed by longer payment terms and past-due customer balances, according to the American Productivity and Quality Center (APQC). Over the past year, the number of finance managers prioritizing late customer payments as a top cashflow management concern increased by 10 percentage points, APQC research found.
Perry D. Wiggins
Tracking and intentionally managing a helpful pair of metrics — namely, days payable outstanding (DPO), which I discussed in detail last month, and days sales outstanding (DSO), which I will dive into in a moment — provides a set of concrete levers for achieving optimal liquidity.
By understanding and balancing these metrics, CFOs can improve cash flow and build cash reserves. Doing so provides the flexibility to adapt to and align with strategic goals, market shifts, and external economic conditions.
What is DSO?
DSO measures the average number of days it takes an organization to collect payment from its customers. The amount of sales outstanding expressed in days is calculated as:
![Days sales outstanding calculation](https://d12v9rtnomnebu.cloudfront.net/diveimages/dso.png)
Exclude all unbilled receivables when calculating this measure.
APQC finds that top performers (in the 25th percentile) on this metric get paid in 30 days or less, while bottom performers (75th percentile) take 46 days or longer to collect. Companies at the median take 38 days or less, on average, to collect payment on customer invoices. Keep in mind these figures reflect cross-industry data. A “good” DSO score will vary by industry and business type. For that reason, you should benchmark your DSO against peer organizations for the best assessment of your performance.
Pairing a low DSO with a high DPO (a measure of how long it takes your organization to pay vendors and suppliers) maximizes cash on hand. However, achieving an optimal DSO requires careful consideration of your market, positioning and customer relationships. Once you establish a target DSO, you can track the metric and manage accounts receivable to make sure you hit it consistently.
Get cash more quickly
There are some tried and true strategies for lowering DSO, and some of them are now easier to execute — even for small organizations — than ever before. For organizations still taking payments via paper checks and phone calls, facilitating electronic payments is the fastest and easiest way to reduce DSO.
Another common culprit of a higher-than-desired DSO is a cycle-time gap. Preparing invoices on Monday but not transmitting them to customers until Friday drives up DSO. Automation generally reduces cycle time, cuts down on errors and has been shown to generate significant bottom-line benefits in a short timeframe.
Once customers receive the invoices, do they pay on time? If your payment terms specify 30 days, but payments frequently arrive after 40 or 45 days, this represents an opportunity. A gentle email nudge 10 days after invoicing, to confirm receipt and remind customers of the payment terms, can lower DSO.
Finally, do your payment terms have teeth? Adding late-payment penalties (and early-payment incentives) or instituting credit restrictions promotes timely payments. Requiring an initial deposit or down payment also improves cash flow.
Consider your customer
While process automation and stronger, clearer payment terms are useful for reducing DSO, they won’t bring in cash from customers who are intentionally delaying payment. By examining the payment histories of major customers and customer industry segments, you will get a clearer picture of payment speeds across the customer base.
It’s important to consider the context of the customer and the relationship during discussions about payment terms.
When doing business with larger, more established firms, it might behoove you to tolerate a longer payment term, if possible, to keep the relationship strong. Allowing strategic, established partners more time to pay will drive up your DSO, but in an intentional way that serves the interests of your organization. Keep lines of communication open with these customers and have a specific contact person who can work with you through any extended payment delays.
On the other hand, when customers are individuals or smaller businesses, being more rigid about payment terms is usually a better approach. But, when necessary, negotiate a payment plan.
The cash balancing act
When managing cash, you want a predictable and stable environment, not peaks and valleys. Ideally, DSO and DPO balance each other out.
However, external disruptions on the global stage, in the economy, or within the supply chain inevitably affect how organizations manage their cash. These changes can be temporary or, as we are seeing in this post-COVID-19 era, they can become permanent.
Ultimately, as all businesses adopt readily available tools to provide online payment options, I believe payment friction will subside. As in most areas of business, pairing technology with ingenuity and strong interpersonal communication will pave the way for organizations to strike the right balance.
Perry D. Wiggins, CPA, is CFO, secretary, and treasurer for APQC, a nonprofit benchmarking and best practices research organization based in Houston, Texas. Data in this content was accurate at the time of publication. For the most current data, visit www.apqc.org.