Cash flow management is a tricky and challenging endeavor, especially when working in the construction sector. Transactions in the construction business are often done through a credit system, and this can cause serious cash flow issues if your company has poor credit management policies.
It is therefore imperative for every company to regularly assess their cash flow and credit management practices and to determine any points of inefficiency. Beyond establishing a good and trustful relationship with your clients, having a valuable metric to determine whether you are managing your company as efficiently as possible is just as important.
One concrete way to measure the health of your cash flow is to use a metric known as the days sales outstanding or DSO. The DSO allows you to quantify how long it takes for your company to collect the payment for your credit sales. Credit management departments generally strive to reduce their DSO and shorten the wait time for their clients to pay all outstanding balances.
- What is DSO or days sales outstanding?
- Why is DSO important?
- Why is DSO an important KPI for construction credit departments?
- How do you calculate DSO?
- What is the formula for computing DSO or days sales outstanding?
- How do you interpret the calculated DSO?
- Why should you reduce your DSO?
- 5 Tips for DSO reduction
- Issues and Limitations of DSO
- How do you set the right trade credit limit?
What is DSO or days sales outstanding?
DSO or days sales outstanding is, to put it simply, the average payment collection period of a company. It is a single number that quantifies the amount or length of time that it takes your company to collect payment from your clients.
In an ideal scenario, all sales are paid upfront. The client will give you the money right away in exchange for the services that your company provides.
In reality, however, most sales in the construction sector are credit sales. Your clients avail of your services or materials without paying immediately. Your clients are instead given an invoice and a deadline to pay. The DSO is then used by many companies to measure how long it takes for their customers to actually settle the payment.
Knowing the following accounting definitions can help you understand DSO better:
- Account receivables
This is the remaining amount of money that is due to your company for the services that you have already furnished or delivered to your client.
- Credit sales
These are sales that are settled or paid at a future date after services have been rendered or materials have been provided.
- Payment terms
These are the rules surrounding your payment agreement with a client. It details any special offers (e.g., early payment discount) as well as payment deadlines.
Construction services, be it labor or materials, are often provided as credit sales. Since payment disputes and delays are common in construction, companies must always consider their DSO when assessing the effectiveness and efficiency of their payment and credit policies.
Why is DSO important?
DSO is a standard accounting metric that is used across all industries, and it is an important business metric in various ways. Not only is it a verifiable value that sums up an important aspect of a business’ finances, but it is also a helpful tool that can help managers identify points from improvement in a company’s credit management practices.
Why is DSO an important KPI for construction credit departments?
The following are three specific ways why knowing how to do DSO analysis is important for every company, especially for their credit managers and account receivables staff:
- DSO analysis helps a company assess the effectiveness of their payment collection practices.
The DSO is only a number, but it can tell a lot about a business and its financial status. When a DSO is high, for example, it means that a company takes a long time to collect payment from their clients.
A high DSO can also imply that a company has limited cash on hand since they have pending payments from clients that take a long time to get settled. The DSO can therefore help credit managers identify potential loopholes in their collection practices and consequently fix them.
- DSO analysis helps upper management assess how well a credit management department is doing.
CEOs and CFOs often look at the company’s DSO to determine how well their business is doing. Upper managers also look at the DSO to know if their credit managers and account receivables department are doing their jobs properly.
The DSO may be measured monthly, quarterly, or even annually, and upper managers can assess the trend for how the DSO fluctuates at a given time. While the DSO is not the only valuable metric in accounting, it is still a relevant number that most upper managers ask for.
- DSO analysis helps credit managers evaluate the payment capabilities of their customers.
Analyzing a company’s DSO can also be applied on a customer level. Instead of mapping the trend for how a company’s average payment collection period changes over time, a company can also use the DSO to study a specific client and how quick or slow they settle their outstanding payments.
Understanding which of your clients are having issues with payment is important. It will allow you to address the root of the payment issue and help solve it. For instance, you can ensure that your clients serve preliminary notices on time so they can file a mechanics lien to recover their payment.
How do you calculate DSO?
- Determine whether you want to perform a monthly, quarterly, or annual analysis.
The first step is to determine the specific period over which you will conduct your DSO analysis. Do you want to calculate your company’s DSO for the past month? The past quarter? The past year?
Annual DSO analysis is the most common, but it does not mean that you should only calculate your DSO per year. Quarterly DSO analyses may be done when trying to understand how a company’s payment collection average has improved or dwindled every quarter. Monthly calculations may also be done when assessing a specific client’s payment settlement average.
- Collect the required information.
There are three pieces of information that you need to calculate the DSO:
- The number of days in the specific period covered by your analysis (e.g., annual equals 365 days);
- The amount of your account receivables in the given period; and
- The amount of credit sales made in the given period.
Most credit managers of mid to large-sized companies should have access to the information above. Smaller companies may need to look at their statement of accounts to determine their accounts receivables and credit sales for the analysis period.
When you have identified the time frame for your DSO analysis and you have all the key details ready, you may proceed with calculating the DSO.
What is the formula for computing DSO or days sales outstanding?
The formula for calculating the DSO is as follows:
DSO = (Accounts Receivables / Credit Sales) * Number of Days
Accounts receivables correspond to the amount that is due to the company for services that have already been rendered. If you are conducting a DSO analysis that covers multiple months, you may need to take the average of accounts receivables you have within the period.
The table above illustrates the accounts receivables for the first quarter of a year. When calculating your DSO for the first quarter, you need to take the average of all three amounts. This average is what you will plug into the DSO formula above.
Average Accounts Receivable = ($10,000 + $12,000 + $10,000) = $10,000
Credit sales correspond to the amount of sales without immediate payment. The credit sales must account for all applicable sales made within the established time frame. Returns and adjustments must also be subtracted before the credit sales amount gets plugged into the formula.
If a company, for example, makes $25,000 of credit sales within the first quarter and has a return of $5,000, the total credit sales to be used in the Q1 calculation for the DSO should be $20,000.
Number of Days
The number of days counts the number of days within that time frame. An annual DSO analysis, for example, will have 365 or 366 days, while a monthly DSO analysis will have 30 or 31 days. A first-quarter DSO analysis will have 90 days.
In the example above, the DSO will be calculated as follows:
DSO = ($10,000 / $20,000) * 90 = 45 days
How do you interpret the calculated DSO?
The DSO tells you the average number of days that it takes your company to collect payment from your clients. In general, the DSO may be interpreted as follows:
- The lower the DSO, the fewer days it takes for a payment to get settled. A low DSO is therefore a good indicator for most companies. It could mean that a company’s payment collection practices are effective, or that they have a good client base who all pay quickly.
- The higher the DSO, the longer it takes for your clients to pay up. A high DSO is generally not a good sign but note that bigger companies may still have a strong cash flow despite having a high DSO.
There are numerous factors that must be considered when interpreting a DSO. When determining what makes a DSO “high” or “low,” it is important to consider factors such as location and industry.
A 2019/2020 study by PwC suggests that the average DSO for the engineering and construction sector in the US is 90 days. Ideally, you do not want to go beyond this 90-day average.
You could also compare your DSO to your payment terms. Your DSO should not go beyond 50% of your average payment terms. If you set a payment term of 30 days for most of your clients, your DSO should not go above 45 days, which is 15 days more than your average payment term.
Why should you reduce your DSO?
Some companies may want to reduce their DSO to the national average, while others want to match their DSO with their average payment terms. There is no standard number for the ideal DSO, but reducing the DSO is almost always a reasonable goal.
This is because DSO is closely linked to a company’s cash flow. The sooner the clients pay up, the sooner a company gets liquid assets that can be used towards their payables. The lower your DSO, the sooner you have the money to purchase more materials and cover your payroll, among other expenses.
Meanwhile, a high DSO can potentially cause serious issues for your company down the line. Unless you have the funds to cover all expenses without relying on the unpaid balances from your clients, you might need to revisit your credit management practices and payment collection policies if your DSO is no longer within a reasonable range.
5 Tips for DSO reduction
Identify the root cause of payment delays.
If your clients are not able to pay on time, it is best to determine what causes the delay to begin. Are your clients working with delinquent owners or contractors who do not pay on time? Are they having short-term financial issues?
It will help a great deal if you ensure that your clients have submitted the applicable preliminary notices. In most states, serving a preliminary notice ensures that a construction participant preserves their right to filing a mechanics lien. If your client can leverage their lien rights against delinquent owners, they have a higher chance of getting paid on time. In turn, they can also pay you sooner.
Offer incentives for quicker payments.
You may have clients who may not necessarily pay late, but they do not pay early either. One way to reduce your DSO is to get your clients to pay earlier. You can do this by offering incentives for early payments. You can, for instance, offer a discount if a client pays before the payment deadline.
Early payments can reduce your accounts receivables in a given DSO analysis period, which, in turn, reduces the overall DSO.
Implement late payment penalties.
Penalizing your clients for paying late can also be effective in imposing the payment deadlines. The construction sector is notorious for late payments, but your clients may try harder to avoid paying late if doing so means losing money. Be reasonable when determining your late payment fees. You do not want to charge an amount that could potentially drive your clients away.
Build an efficient invoicing policy.
Sometimes the problem is not about the client but about your own invoicing policies. There are clients who may be willing to pay immediately as soon as they get the invoice. It is therefore very important that you send out your invoices early. The later you issue your invoice, the more time passes before your client processes their finances and releases the payment.
Revisit your credit management practices.
When your DSO is high, there may be issues with how you handle the credit accounts of your customers. Do you have a vetting process when determining the credit limit of your clients? Are you offering longer payment terms just to boost your sales? Are there any efforts to automate payment collection?
By asking these questions, you may be able to address issues with your internal credit management policies that may be causing the high DSO.
Issues and Limitations of DSO
DSO is an important KPI for construction businesses, and it still comes with limitations. DSO is only one metric, and there are nuances that it is not able to capture.
- Sales are seasonal.
Construction sales can be seasonal. Some months may have higher sales than others, and short-term fluctuations in sales can affect the DSO. These fluctuations are not captured when an annual DSO is calculated. A CEO may think that the credit managers are not doing their jobs properly because of a high annual DSO, even though the increase was due to a short-term slow sales period.
- Cash sales are not considered.
The DSO primarily applies to credit sales, and it does not take into account cash sales. This metric, therefore, does not fully capture the full picture of a company’s finances. It is limited to sales made on credit, which makes it a helpful tool for companies who offer more credit sales than cash sales.
How do you set the right trade credit limit?
To avoid steep increases in your DSO, it is important that you set the appropriate credit limit for your clients. The trade credit limit that you offer must be within your customers’ means without going too low that they would rather do business with another supplier.
When determining the right credit limit for your client, consider the following:
- Watch out for red flags.
Be diligent when conducting your research. Verify the qualifications of your customers’ references, and do not ignore questionable business histories, including a long record of acquiring mechanics liens.
- Monitor the credit record of your existing clients.
While vetting your new clients, you should also not lose sight of your existing client base. They can be going through financial or ownership changes that can affect their ability to settle their outstanding payments.
- Separate the estimates from actual numbers.
When analyzing your client’s records, you should be able to determine which numbers are mere estimates and which are actual values. This should help you judge how stable your customers’ financial states are.