Introduction:
Days Sales Outstanding (DSO) serves as a critical metric in financial analysis, reflecting a company's effectiveness in collecting receivables. While the traditional formula, involving average debtors, is a common approach in textbooks, it may not fully capture the complexities of real-world scenarios. This is particularly evident in industries like retail, where sales patterns can be highly seasonal. In this article, we compare the traditional method with alternative frameworks, discussing the inherent limitations and considerations of each.
Understanding limitations of standard DSO formula:
Consider a retail company with opening debtors of 36, closing debtors of 40, and total annual sales of 100, distributed across quarters as follows:
| 1Q | 2Q | 3Q | 4Q | Total |
Revenue | 18 | 12 | 15 | 55 | 100 |
DSO calculated using standard textbook formulae would be around 139 days calculated as follows:
DSO = Days in the Period * Average Debtors / Total SalesAverage debtors would be equal to (36 + 40)/2 = 38.
Therefore, DSO = 365 * 38 / 100 = 138.7 days.
But the year-end debtors of 40 is less than Q4 sales, implying that DSO should be significantly less than 90 days. Therefore, there is an inconsistency between the business reality and what the formula gave.
The reason for the inconsistency is that standard DSO makes several simplifications:
It ignores the seasonality aspect of business. The number of 138.7 days we arrived may be closer to reality if the company sold INR 25 in each quarter.
The formula for calculating average debtors – just using the opening and ending debtors – obscures fluctuations in debtor balances.
Thus, in industries like retail, where sales and collections may not align neatly within a fiscal year, the traditional DSO calculation may not accurately reflect the business reality.
This also calls for more nuanced approach when it comes to calculating DSO. In this article, we propose three alternative frameworks.
Alternative 1: Weighted Average Collection Period
This is a very intuitive approach where we look at the actual time it took to collect each invoice. In order to calculate this, we, however, need all the invoice data. An illustrative data set is given in the table below:
Revised Illustrative Data Set:
Here's how it works:
To calculate the weighted average collection period, each invoice's collection period is multiplied by its amount, and these products are summed up. This sum is then divided by the total sales amount:
Weighted Sum of Collection Periods = ∑(Amount × Days to Collect)
Total Sales = ∑Amount
Average DSO = Weighted Sum of Collection Periods / Total Sales
The weighted average collection period in this case would be 4,063/100 = 40.63 days
Limitations and Considerations:
The traditional DSO formula, though straightforward, might oversimplify and inaccurately reflect actual collection patterns.
The alternative framework offers a detailed perspective, but it has two limitations:
(i) It ignores the lag between invoicing date and the actual date in which goods or services were delivered.
(ii) Outstanding invoices where payments are yet to be received will either have to be ignored or we may have to use an assumption for the expected collection date.
This approach is also not viable for external parties such as bankers or investors who may not have access to such granular invoice level data.
Alternative 2: Computing DSO over shorter time frame
Another framework worth exploring involves analysing DSO on a quarterly basis. This method can be particularly insightful for businesses with significant seasonal variations in their sales and collection patterns.
To illustrate this approach, let's use the provided debtor balances at the end of each quarter
Q1: 13
Q2: 8
Q3: 10
Q4: 40
And the quarterly sales figures are as previously mentioned: Q1 - 18, Q2 - 12, Q3 - 15, Q4 - 55.
DSO for each quarter is calculated using the formula: End of Quarter Debtors / Quarter Sales × Days in the Quarter
Let's calculate the DSO for each quarter:
Q1 DSO: 13/18×90 = 65
Q2 DSO: 8/12×90 = 60
Q3 DSO: 10/15×90 = 60
Q4 DSO: 40/55 = 65.5
After calculating the DSO for each quarter, the next step is to find the average of these four DSO figures to get the annual DSO. Thus, we would arrive at an average DSO of approximately 63 days.
Analysis and Limitations:
This approach takes into consideration the seasonal variation and doesn’t require daily invoice collections. However, like the other methods, it has its limitations. For instance, it might not fully account for long-term receivables or outstanding invoices that span multiple quarters. Moreover, this method assumes that the sales and collections within a quarter are evenly distributed, which may not always be the case.
Alternative 3: FIFO method
The FIFO-based DSO is calculated by assuming that sales are collected in the order they were made. Therefore, the debtors outstanding is first assigned to the recent most period and is then work backwards.
To illustrate, let us assume the debtors at the end of the year is INR 60 instead of 40.
The first 55 out of the 60 outstanding would be attributed to quarter 4. The balance 5 is attributed to quarter 3.
Quarter 3's total sales was 15. Therefore, the 5 pertaining to the quarter 3 would be equal to 30 days sales of that quarter. This 30 days is computed as 5 / 15 * 90 days.
Since the entire Q4 sales is outstanding and approximately 30 days of Q3 sales is outstanding, we would conclude that the average collection period is 120 days.
Quarter | Sales | Allocated debtors | Balance to be allocated | DSO for allocated debtors |
Start | | | 60 | |
Q4 | 55 | 55 | 5 | 90 |
Q3 | 15 | 5 | 0 | 30 |
Total | | | | 120 |
Analysis and Limitations:
This method provides a valuable perspective, particularly in contexts with significant seasonal sales variations, by aligning the DSO calculation with the actual sales and collection timeline. It offers a more dynamic understanding of a company's collection efficiency, illustrating the impact of seasonal sales and the importance of considering the timing of sales and collections in financial analysis. It can also handle long-term receivables.
Synthesizing Insights for a Holistic Financial Analysis Approach
This exploration into DSO calculations brings into focus that finance is not a pure science and it still involves a significant amount of subjectivity. It also reveals the importance of understanding the strengths and limitations of textbook formulae. Recognizing these nuances allows financial analysts to adopt a more comprehensive approach in their financial analysis of different industries. Continuous evaluation and adaptation of these metrics are key to accurately assessing a company's financial health in a complex business landscape.