Most business owners and financial managers know the importance of their investment in accounts receivable. The method by which the largest corporations in the world, and a small company measure collection activity, is called DSO, or 'Collection Period'. DSO stands for DAILY SALES OUTSTANDING.
Business owners can calculate this number very quickly, and we recommend it be done regularly, typically monthly, quarterly, and certainly annually. It's a great business measurement of your success, and lenders also focus in on this number also.
How is the DSO calculated? It's an easy calculation, as follows:
Accounts receivable / average daily credit sales
The answer is expressed in days - e.g. 'Our DSO is 40 days '
Again, we emphasize this is the traditional measure of success in monitoring a company's investment in accounts receivable. In our above example we said the DSO number was 40 days. So what? Is that good or bad. Well, we benchmark against our selling terms. A great portion of industry revolves around payment terms to customers of 30 days. (We can hear most business owners saying 'I wish..."!) If our customers, on average are paying us in 40 days, and our terms are 30 days, you can see there is a ten day additional carrying of accounts receivable.
So the bottom line is that the longer the DSO the more focus management has to pay on account receivable collections. Business owners know all too well bills and employees are paid with cash, not profit!
In most businesses as sales go up many financial controls go down. That's unfortunate of course, but the fact is that many firms that have explosive sales growth tend to de-focus on DSO, as that measure is masked by sales growth and profit. Management and sales personnel are often favoring loosening credit standards to meet revenue and profit goals.
We point out that the DSO calculation is a reflection of one point in time - that's why it is important to monitor the overall trend of DSO on a longer term basis. Naturally all good businesses age their receivables, so they know how old they are and focus on past due accounts. When a company selling on 30 day terms has a significant investment in 60 and 90 day receivables we can very accurately predict that DSO quality is declining.
Naturally in difficult and recessionary times everyone is holding onto cash longer, and only management can focus on specific actions such as improving collections.
Focus on DSO improves working capital and overall business cash flow - so it's a valuable asset in any owners 'financial toolkit 'to working capital improvement.
Is the Lack of Cash Flow and Working Capital My Firm's Doomsday?
Business owners and financial managers know the importance of cash flow and working capital as generated by their accounts receivable and inventory accounts. What is the ultimate effect of a lack of cash flow and working capital - we know the answer - it is a business failure.
Business owners can utilize a financial analysis technique that finance textbooks call the 'DOOMSDAY RATIO '. What is that ratio and what is its significance?
The Doomsday ratio is calculated by the following easy formula:
Cash divided by Current Liabilities.
This is one of the most powerful and effective solvency ratios that a business owner can utilize. Business people might be aware of two other similar ratios, the current ratio and the quick ratio. The current ratio included the firm's current assets, including accounts receivable and inventory. The Quick ratio did the same but excluded inventory.
The business owner can quickly see that the doomsday ratio focuses solely on Cash! We can call it a very demanding ratio because it focuses solely on the liquid gold within the company, cash! As liquid as your receivables and inventory are, they aren't cash yet, and everyone knows the day to day business challenges of converting receivables and goods into a final cash customer payment.
Really the best way to look at the Doomsday ratio is to view it as an ongoing measure of the firms cash 'buffer'. The bottom lien is that it will show the business owner what 'cushion' of cash the firm has. Business owners could even choose to monitor the ratio daily, as it could very well warn against impending shortages of working capital.
Many business owners know that it is also not productive to carry cash on hand, particularly in today's low interest rate environment. So it makes common sense that the doomsday ratio may in fact be less than one, but at least we have a number that, on an ongoing basis, we can monitor.
Each business over time has a philosophy and business practice around how much cash is kept on hand. Naturally it's also obvious, and important to know that if you reduce your operating line of credit with you cash you still have the full liquidity of your operating line, but you aren't paying any interest to borrow. That's a good strategy also.
Customers can also enhance their position by factoring or selling their accounts receivable, which would put them in a strong position to generate cash and maintain a positive Doomsday Ratio.
In summary, the analysis technique is a valuable took to monitor cash flow/working capital for any business.
