Our company currently factors in unbilled revenue or contracts that have been signed but no revenue incurred yet in our calculation of DSO. Are these appropriate DSO calculation methods? We also only invoice customers at month end, so in calculating DSO percentages during the month, it seems our calculations are not very accurate. Can you pls advise on best practices here.
Wondering best practices in the formula for calculating DSO?
Answers
Best practices for any metric begins with understanding what we are trying to accomplish by measuring DSO. This may be for measuring and rewarding performance or this may be for external reporting to financing sources.
Let's take PERFORMANCE MEASURES first. What behaviors are encouraged by various DSO formulas? If we exclude earned but unfilled revenue, we may lose urgency for billing customers that, in turn, will slow our cash cycle. Similarly, if we measure only at the end of each month, folks lose all incentive for urging customers to submit payments and earlier than the last day of the month.
Think through the impacts on motivations very carefully when establishing performance measures. As I heard a manager so eloquently (but frighteningly) put it, "Just tell me what the rules are and I'll play the game." Most employees aren't so deviously calculating, but even unconsciously, they will be nudged toward or away from desired behaviors.
If you are providing DSO to FINANCING SOURCES, it need not be the same formula used for performance measures, but our method should not be dictated by what we think makes us look good. Check first for GAAP or industry standards and expectations.
If there are no GAAP or industry standards for your situation, then put yourself in the shoes of your equity and debt providers: Why are they asking for DSO and which formula would give you the best understanding of what's really going on in your firm? DSO provides insights into your
In your particular situation, billing only at the end of the month creates a distortion, but if you have earned that revenue, including it in DSO is probably a more accurate reflection of reality. But again, start with why you are measuring DSO to arrive at the best 'how'.
Thank you very much for your discussion above. The two major things we would like to measure are 1) How long it takes our company to collect revenue. This is important because we pay vendors based on this revenue and we do not want to pay these vendors prior to the revenue being collected. 2) Our company wants to ensure we are making progress, or at least staying constant in DSO as our receiveables increase. Given these two measures, do you have advice on the formula you would use to calculate DSO and whether you would include sales contracts signed but not no revenue incurred (unbilled revenue) and revenue that has occured but not yet invoiced? Thank you.
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If you want to measure collections you should exclude revenue that has not been billed, you're looking at collections and you can't expect to collect things you haven't invoiced. The decision you need to focus on is how large a bucket of sales to include when calculating what is equal to 1 day's sales. If you use an annual sales number divided by 365, you'll get a smoother result over time, but probably not the sensitive metric it sounds like you are looking for. If you use the sales that relate to your offered sales terms (e.g., if you sell on net 30, take the most recent month of sales divided by thirty days) you'll get a short term metric that is volatile, but relates to the current activity and relates to your stated sales terms.
I would clarify one thing from your post. You question whether you should include "contracts signed but no revenue incurred (unbilled revenue)" and/or include "revenue that has occured but not yet invoiced". I think you have those reversed -- the latter scenario is unbilled revenue, i.e. you have recognized revenue but not billed it yet, so it is sitting in WIP. I think its useful to look at DSO for both AR, and AR+WIP together. That gives you one indicator of your collections, as well as an indicator on your total time to collect including the time it takes you to get your invoices out. Assuming that you are matching revenue to expense with some accuracy, then for your first purpose of DSO reporting (how quickly to pay vendors) you want to "start the clock" when revenue (and expense) are recorded so that you're matching your payment terms with your vendors appropriately. Said another way, if you generally have 30-day terms with your customers but it takes you 30 days to generate invoices, you'd probably want 60-day terms with your vendors if cash is a constraint (of course they're going to want something in return for extended terms).
Going back to signed contracts where you haven't recognized revenue, perhaps what you meant there was unearned revenue. If you have this on the balance sheet its probably because you were able to bill in advance of doing the work. In that case, I would include this as well as a reduction to your AR + WIP because it actually benefits your DSO.
Our Company, a custom manufacturer in the Photonics industry, uses a DSO metric which we calculate as the equivalent number of days sales in our monthly closing accounts receivable balance (A/R) with reference to two bases, a)the current month's sales annualized and b) trailing 12 month sales. We find that using these two measures give us a better understanding of both the overall trend as well as our current A/R situation while recognizing fluctuations in sales, sales timing and collection activity, on a month to month basis. In our case, Sales equates with GAAP revenue (shipments).
Formula:
a) ending A/R balance divided by (monthly sales x 12)times 365
b) ending A/R balance divided by trailing twelve month sales times 365
I have seen others use a different denominator based on actual business days but we prefer the calendar day approach.
We maintain a DSO worksheet which tracks Sales on a monthly, quarterly and annual basis and monthly A/R balances. We also calculate a yearly average DSO for each of the annualized and trailing twelve month metrics to measure our average performance during each fiscal period.
Not sure if this is as appropriate to your particular business. The key is to maintain a consist approach that provides you with an ability to measure trends and performance in A/R management. Hope this is useful.
Our company is a global manufacturer with a significant percentage of sales being seasonal and generated outside the US. One of our considerations was a formula that would smooth out the extended terms associated with our seasonal business. We currently use a 13-month moving average DSO formula.
I wouldn't worry too much about the formula because the real value in measuring DSO is to let you know each month whether your collections and free cash flow are improving or deteriorating so that you can take corrective action.
Separate the receivables for what you want to accomplish. For example, measure the DSO for billed receivables to evaluate your collections efforts. And also measure the DSO for anything that is unbilled to evaluate invoicing and management around this activity.
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