What is days sales outstanding (DSO) and how can you manage it?
In this quick read, we’ll introduce you to Days Sales Outstanding (DSO). By the end of the article, you’ll be set to measure and improve your own cash flow.
Maintaining a healthy cash flow for professional services firms is essential to sustaining operations and growth. A key metric that helps firms assess their financial health is DSO (DSO stands for Days Sales Outstanding), which measures how long it takes to collect payment from clients after services have been provided. A well-managed DSO allows firms to maintain a smooth cash flow, while a high DSO can result in cash flow problems and operational disruptions.
This article delves into the importance of DSO for professional services firms, how to calculate it, and practical strategies for managing it.
What does days sales outstanding (DSO) mean?
Days Sales Outstanding (DSO) measures the time it takes for a firm to collect payments from clients after invoicing them for their services.
This is particularly important for firms that operate on credit, as slow client payments can significantly impact their ability to cover expenses, pay staff, or invest in growth initiatives.
For professional services firms, where large projects and long-term client relationships are common, tracking DSO is crucial for understanding how efficiently capital is converted from billed hours or projects into revenue. A high DSO means your firm is waiting longer to get paid, while a lower DSO indicates faster collections and a healthier cash flow.
How do you calculate DSO?
Calculating DSO for a professional services firm is straightforward. Here’s the formula:
DSO = (total accounts receivable ÷ total credit sales) x number of days in the payment period.
In this context, “accounts receivable” refers to the total value of unpaid invoices issued to clients for completed projects or services rendered. “Credit sales” are the total value of sales made on credit to clients, typically over a 45-day or 90-day period. Net credit sales x number of days is a key factor in calculating DSO, and it determines how long your firm is waiting to collect payments.
Example of DSO calculation for a consulting firm:
Suppose your firm has $200,000 in accounts receivable and $800,000 in total credit sales for a 30-day period. Using the DSO calculation formula:
DSO = (200,000 ÷ 800,000) x 30
This calculation indicates that, on average, it takes your firm 7.5 days to collect payment from clients. A lower DSO like this is a positive sign, suggesting that your clients are paying on time, which helps maintain a steady cash flow.
What is considered a “good DSO”?
According to Dun & Bradstreet, a DSO lower than 30 days is generally considered excellent, indicating that clients pay promptly, helping firms maintain a healthy cash flow.
In contrast, a DSO above 60 days can signal inefficiencies in the collection process, leading to potential cash flow problems. Firms with a higher DSO may face operational challenges as they wait longer to convert their work into revenue, impacting their ability to cover costs or reinvest in the business.
Tips for improving your firm's DSO
Managing Days Sales Outstanding is essential for maintaining a healthy cash flow in professional services firms.
Here are some strategies for managing and reducing DSO:
Outline how you receive payments in your professional services contract
One of the most effective ways to manage DSO is to set clear and concise payment terms in client contracts. Standardizing payment terms, such as requiring payments within 30 or 45 days, sets client expectations and ensures both parties are aligned. Avoid ambiguous terms like "payment upon receipt," which can lead to delays.
Use software to automate your invoices
An automated invoicing system can significantly reduce the time and effort required to manage billing and improve your DSO. You can ensure accuracy and streamline the invoicing process by leveraging software that generates invoices directly from timesheet data or predefined project milestones. Additionally, integration with accounting platforms like Xero, QuickBooks, or MYOB allows for seamless syncing of invoices, ensuring that payments are tracked and cash conversion cycles are managed efficiently.
Maintain strong client relationships
Keeping your clients closely informed throughout a project is critical to managing DSO effectively. By maintaining open lines of communication, you can ensure clients are always aware of project progress, deliverables, and billing timelines. Regular updates and transparency around costs help prevent surprises when the invoice arrives, reducing the risk of payment delays.
Perform your due diligence before taking on large projects
For large projects, performing due diligence on a client's financial stability is essential to managing DSO. Before committing significant resources, checking whether the client can meet payment obligations is important. This can involve conducting credit checks or researching the cocompany'sealth to identify potential risks.
Offer multiple payment options
Providing flexible payment options through platforms like Xero or QuickBooks makes it easier for clients to settle invoices quickly. Clients can pay via credit card, bank transfer, or direct debit, offering convenience and reducing friction in the payment process.
Incentivize prompt payments
If your firm finds you often receive late payments from clients, you can try offering a small discount for early payments. For example, providing a 2% discount for invoices paid within ten days can encourage clients to pay sooner, improving your fifirm'slow.
Review your billing process
Inefficiencies in your billing process can contribute to a high DSO. Ensure invoices are accurate, easy to understand, and sent immediately after services are delivered. Delays in issuing invoices or incorrect details can slow down payment collection.
As a last resort - try late payment penalties
To encourage timely payments while maintaining strong client relationships, including clear late payment penalties in your contract is helpful. However, these should only be enforced when absolutely necessary. Providing clients with reminders and ample notice before the payment due date can often prevent the need to apply penalties, helping to maintain a positive and cooperative relationship. Clearly outlining these terms upfront sets expectations without straining client rapport, while also protecting your firm from potential payment delays.
Regularly track and analyze your DSO
Lastly, consistently monitoring your firm’s DSO is crucial for identifying trends and potential issues. Regular analysis allows you to spot patterns of late payments or problem clients early so that you can take corrective action.
Set benchmarks for your firm’s DSO and review it monthly or quarterly to stay on top of cash flow management. Keep your sales teams involved, ensuring they understand the importance of DSO and its impact on revenue collection.
According to the 2024 Professional Services Maturity Benchmark Report, top-performing firms tend to have a DSO in the 30 to 45 days range, while average firms can see a DSO closer to 50 to 60 days.
Why managing DSO matters for professional services firms
A well-managed DSO is critical to the financial health and op’ financial health and operational stability. By shortening the time to collect payments, firms can ensure sufficient cash flow to cover payroll, invest in growth initiatives, and maintain strong client relationships. On the other hand, failure to manage DSO can result in cash flow problems, difficulty covering operating expenses, and the need to take on debt to stay afloat.
Moreover, a high DSO can affect a firm's reputation, particularly when seeking investment or credit. Lenders and investors often view a consistently high DSO as a sign of inefficient cash management or risk, which could hinder growth opportunities in the future.
Automation for managing DSO
Days Sales Outstanding (DSO) is a crucial financial metric for professional services firms, offering insight into how efficiently a business converts its work into revenue. Managing DSO effectively is not just about ensuring timely payments; it's about creating a stable financial foundation that supports your firm’s firm and operational efficiency.
For professional services firms, where large projects often come with longer billing cycles, keeping a low DSO can prevent cash flow bottlenecks and ensure that your firm has the liquidity to meet expenses, invest in new opportunities, and maintain positive client relationships. High DSO, on the other hand, can result in late payments, which strain your cash reserves and can lead to operational challenges like difficulty covering payroll or taking on new clients.
Automating your billing process is one of the most impactful steps you can take to manage DSO better. Automating invoicing ensures that invoices are sent as soon as milestones or projects are completed. At the same time, integrated systems like Xero or QuickBooks provide clients with flexible payment options and keep track of overdue accounts.
Automation minimizes manual errors that can cause delays and strengthens communication with clients through automatic reminders, reducing the likelihood of late payments - and therefore, shortening your DSO.
