You need a constant flow of cash in your business to run your operations smoothly, and while much has been written about how to improve your cash flow, one simple fact remains: the faster you collect your accounts receivable, the better your cash flow situation will be. But what a lot of business owners don’t account for is the cost involved in carrying overdue receivables, and how, by reducing those costs, the cash begins to flow more freely. Here’s how shortening your daily sales outstanding (DSO) can in turn improve your cash flow and your business’ overall financial health.
What Is Daily Sales Outstanding?
DSO is the average number of days it takes you to collect the cash after you’ve made a sale on credit. When the number is low, it means you’re doing a good job of collecting. But if your number is high, it means you need to step up your collection efforts. Use this formula to calculate your DSO:
Accounts Receivable / Net Credit Sales x 365
For example, if you have $10,000 in accounts receivable, and sold $70,000 in net credit sales (sales that aren’t paid for immediately), it takes you an average of 52 days to collect from your customers. If you have a 30-day terms policy, this number shows that you need to take measures to speed up the rate at which you receive payment.
What a Higher DSO Means to Your Cash Flow
When the cash your business is owed sits in your customers’ bank accounts instead of yours, it negatively affects your finances in a few ways. The most obvious is a loss of revenue. When overdue accounts go past 120 days, it becomes less likely they will be collected at all, and you will lose equal that amount on your pretax income. In addition to lost revenue, you might lose out on an opportunity to expand or otherwise enhance your business because you don’t have the cash to invest.
What’s more, if you don’t have access to money to pay your monthly operational costs or grow your business, you may have to resort to outside financing to fill the cash gap. Interest payments add up quickly, increasing the cash burden on an already strapped business.
You will also incur administrative costs related to collecting the debt, and if you’re forced to refer the account to a collection agency, you will have to pay the agency a percentage of the balance if they successfully collect.
Finally, you have to consider the time cost, which you can calculate by figuring out how much money you would have to invest today at the current interest rate to receive an amount equal to what you will collect from the customer in the future.
How to Shorten Your DSO
Now that you understand how shortening the amount of time it takes to collect your accounts receivable can add to the financial health of your business, it’s time to put a plan in action. Here are some tips for encouraging your customers to pay up earlier.
- Don’t sit on your invoices and wait for them to add up. Instead, invoice customers whenever you deliver a product or service.
- Set up an invoice template that includes important information such as payment terms, due date, and payment options.
- Automate your accounting system so you will be alerted immediately as invoices become overdue.
- Call customers and request payment as soon as an invoice becomes past due.
- Review your books and adjust the terms for clients who consistently pay late. For example, you can start to require full payment from those customers when you deliver products or services.
- Tighten your credit requirements for new applicants.
- Ask for upfront deposits and milestone payments as the job progresses rather than waiting to collect the full balance at the end of the job.
- Offer customers more payment options, including electronic payments.
You work hard for your money, and it doesn’t make sense to suffer financially just because customers aren’t paying their bills on time. When you do what you can to shorten your DSO, you can reap cash flow benefits.