Credit Risk Management

Why DSO is the Best Way to Measure Credit Performance

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Bloomberg News
The average DSO on the sale of precious metals is seven days for Anglo American Platinum Ltd., which mines 40% of the world's platinum.

DSO's sensitivity to so many sales and industry-related factors give it strength, not weakness, in measuring the performance standards of credit departments.

The DSO benchmark is making a comeback.  Yet, despite the ratio's simplicity and benchmark status in the financial world, DSO has arroused controversy with some in the credit establishment who complain that it doesn't fully account for variances in net terms or sales fluctations and, as a result, should not be used as a performance metric for credit departments.  But an analysis by CreditPulse reveals that DSO's supposed weaknesses are actually its strengths.  

Days sales outstanding, also known as DSO, is an efficiency ratio that has one of the most important functions in the world of accounting and finance: measuring the amount of time it takes for a company to turn its credit sales into cash.  It is determined by taking into account the size of the accounts receivable at a given point in time compared to the amount of revenue generated for a given period.  This cross-calculation between the balance sheet and income statement, rare among financial ratios, provides a measure of efficiency and credit quality that is as unique as it is timeless. 

Yet, despite such wide acceptance by accountants, financial analysts and CFOs throughout the corporate world, DSO is viewed with disdain by some in the credit profession on the grounds that "it fails to account for some very important factors that have an effect on receivables and cash flow," as stated in an undated article that appeared on the website of the National Association of Credit Management (NACM), the nation's oldest and largest credit organization. 

But DSO's critics don't stop with NACM.  In March 2014, an unidentified author with Capgemini, a receivables consulting firm, wrote an article entitled "Debunking DSO Myth: Making the Measurement More Meaningful."  The article excoriated the formula as "a much weaker statistic than others" but one that "isn't going anywhere and we have to find a way to work with its limitations." Like NACM, the author also questions DSO's ability to accurately "manage" performance.

Another organization, The Credit Research Foundation (CRF), a non-profit based in Columbia, Maryland, has worked overtime in recent years to discredit DSO.  They argue that something called the Collections Effectiveness Index (CEI) is a better way to measure credit performance.  CEI is a formula more complicated than DSO that doesn't measure time at all but indicates in percentage terms what can be collected based on net terms.  CRF also acknowledges that DSO isn't going anywhere anytime soon.

But what the DSO detractors fail to recoginize is that every preceived weakness is actually a strength that reinforces the ratio's sensitivity and accuracy in reflecting what is really happening on the receivables front, whether by design or not.  For this reason, DSO is well-suited as a Key Performance Indicator (KPI)

So why the fuss?  The evidence suggests that the real problem is not so much with DSO, but what DSO may be telling some credit departments about their performances.  Interestingly, the one common characteristic of all the exotic alternatives, such as the peculiar count-back method, is that they produce a lower DSO figure than what DSO itself produces.  Thus, the alternatives are essentially artificial measurements designed to report better-than-actual results by excluding or altering key components of the AR. 

Below are the five most common criticisms of DSO as reported on an NACM-related website with a response from CreditPulse:

It ignores terms.  A company that sells on 180-day terms and is getting paid according to those terms is technically performing quite well.  They could even be collecting ahead of schedule, getting customers to pay earlier than the terms dictate, but they'll inevitably have a really high DSO figure to the 180-day period.  The metric itself can't account for what's been agreed to in the sales contract.

CreditPulse: On the contrary, DSO IS accounting for what has been agreed to in the sales contract and the figure will accurately reflect the amount of time it takes to get paid whether the payment is influenced by the sales contract or not.  The reason here for a high DSO isn't DSO, its the fact that the company has made a conscious decision to increase its DSO by increasing net terms.  This claim also ignores the fact that net 30 credit terms remain the standard for most companies in the U.S.

It ignores industry standards.  Certain industries demand sellers to sell at longer terms.  A company in such an industry that tries to make sales on tighter terms wouldn't be able to compete.  So, while the credit department's speed of converting the company's receivables into cash may be on par with industry standards, DSO wouldn't account for that fact.

CreditPulse: Just the opposite, DSO reflects industry credit standards more than any other ratio with the possible exception of bad debt allowance.  Longer or shorter credit terms, based on industry protocol, are reflected in the industry DSO benchmarks.  The Credit Standards Index (CSI), a comprehensive database of over 2,000 publicly-traded companies in 70 different industries, shows the extent to which DSO averages vary by industry.  For example, the mining and quarrying industry has a much lower DSO benchmark than software technology. 

It ignores seasonal shifts that have nothing to do with the credit department.  Sales can shift with time edging higher in certain periods and edging lower in others.

CreditPulse: This has long been one of the biggest knocks on DSO but it ignores the fact that if sales has a seasonal component year after year then the change in DSO should be anticipated and factored in year over year, in addition to month-to-month.  Seasonal shifts should be factored in, not excluded from the measurement, in order to truly gauge overall performance. 

It ignores marketing efforts.  Companies may inaugurate a focused marketing campaign that may generate increased short-term sales, but the same promotion could offer longer-than-standard terms to acquire those extra dollars.

CreditPulse: Yet another sales-oriented reason for disavowing a key accounting measurement.  First of all, marketing efforts should never involve the lowering of payment terms.  That's not marketing, it's charity!  But again, DSO will justifiably reflect any change in payment trends, whether company-induced or not, and should not be considered less valuable because of its ability to do so.

It's biased to sales. This is the mother of all complaints against DSO as a measurement of credit department and collection performance.  When sales rise the DSO goes down but when sales shrink the DSO goes up. 

CreditPulse: This has long been the most baseless claim against DSO as it ignores three very important realities: 1) When a company makes a sale it is accounted for on the general ledger with a credit to sales revenue and a debit to the accounts receivable.  Both sales and the A/R increase in tandem, not just the A/R.  2) The lag that creates the fluctuation in DSO in either direction results from the timing of the corresponding debit to cash and credit to A/R for the amounts already on the A/R before the sales period.  In other words, the DSO lag is not caused by a gap between sales and A/R, but by a gap between the A/R and cash collections.  DSO increases when the A/R expands more rapidly than sales and decreases when the A/R recedes more rapidly than sales. Therefore, as long as collections is doing its job on the cash side, the A/R should always be in porportion with sales in accordance with net terms.  This is why DSO is a strong KPI.  3) CSI research shows that dramatic fluctuations in quarterly sales is more myth than reality.  Companies want stable quarterly sales, not volatile sales.  Therefore, if volatility is an issue, a credit department can always use a 90-day DSO average to assess collections performance for variances in monthly sales. 

Written by John Bassford, CreditPulse editor/publisher.