This is the first part in a series of articles explaining how increasing DSO is a red flag that should be investigated.
Introduction
Days Sales Outstanding tells a story about a company’s financials. Simply put, it provides a snapshot of how long it takes for a company to collect payments after a sale. For investors, a rising DSO can illuminate underlying issues or even broader economic shifts. This could indicate potential cash flow problems, deteriorating customer quality, inefficiencies in a company’s collection processes, and more. As we dive in we’ll talk about these potential issues and how to evaluate them.
Calculating DSO
DSO is calculated as:
Where:
- Accounts Receivable represents the amounts due from customers.
- Total Credit Sales represent the aggregate sales made on credit during a specific timeframe. While this can differ from total revenues, it’s important to note that not every company reports credit sales distinctly. Please be aware that our site, currently in beta, uses total revenues as a proxy for credit sales.
- Number of Days typically refers to the days in the period being analyzed.
Ending or Average Receivables?
Average receivables are often used in this calculation to smooth out fluctuations, or to keep consistency with other metrics. Average receivables will provide the average time it takes for a company to collect receivables. However we aren’t calculating DSO to get a smoothed dataset, we’re calculating DSO to flag aggressive accounting practices.
If a company is using aggressive revenue recognition practices to book revenue at the end of the quarter/year this will show up more clearly using the ending balance. For more information, see H. Schilit “Financial Shenanigans, 4th Edition” pages 222-224.
Implications of an Increasing DSO
In addition to poor cash management, and increasing DSO could flag aggressive revenue recognition practices. These practices can artificially inflate revenues compared to the underlying business performance.
Channel Stuffing: Some businesses adopt the approach of recognizing revenue as soon as a product is shipped. By pushing out shipments, to customers, towards the end of a financial period, like the close of a quarter or year, they can book the associated revenue earlier than they might have otherwise. This can mask a slowdown. However this will raise accounts receivable and therefore raise DSO. Investors tracking ending DSO can be alerted to this.
Extended Payment Terms: A company can encourage customers to accept product earlier by providing generous payment terms. This might not impact the customer’s total purchases, however it will allow revenue to be recorded earlier.
Deteriorating Customer Quality: Even worse, a company may be extending payment terms at the request of customers who are experiencing a slowdown and are taking longer to pay their invoices. During economic slowdowns, even creditworthy customers might request to delay payments.
Conclusion
The Days Sales Outstanding metric offers investors a valuable lens into a company’s financial health. As DSO rises, it can highlight potential challenges in cash collection or revenue recognition. However, investors should be cautious, as actions like the sale of receivables can artificially lower DSO, making cash collection appear more efficient than it truly is. Our site scrapes company filings to flag these adjustments.
As with any financial metric, it’s essential to consider DSO in the context of the broader financial picture.