Days Sales Outstanding (DSO) and Days Payable Outstanding (DPO)

Ravi was growing more confident in understanding the financial efficiency of a company but knew there was more to learn. While he understood inventory and asset management, as well as timely collections, he now wanted to explore the time taken to collect payments from customers versus the time taken to pay suppliers. This is where Days Sales Outstanding (DSO) and Days Payable Outstanding (DPO) come in, helping businesses balance incoming and outgoing cash flows.

Days Sales Outstanding (DSO)

DSO measures the average number of days a company takes to collect payment after a sale, providing insight into its collection efficiency and credit management. The formula for calculating DSO is as follows:
DSO = (Accounts Receivables / Total Credit Sales) * No. of Days

For example, consider Company A, which has ₹50 lakhs in accounts receivable and made ₹1 crore in credit sales during the last quarter (90 days):

DSO = (50,00,000 / 1,00,00,000) * 90 = 45 days

This calculation shows that, on average, it takes Company A 45 days to collect payment from customers after a sale.

What DSO tells you

• High DSO: A high DSO suggests that a company is taking longer to collect receivables, which can lead to cash flow issues. Increasing DSO could indicate declining customer satisfaction, lenient credit policies, or ineffective collections.
• Low DSO: A low DSO signifies efficient payment collection, ensuring smooth cash flow for daily operations.

It’s best to compare a company’s DSO within its industry since collection periods vary. For instance, manufacturing companies often have longer DSOs due to extended credit cycles, while retail businesses generally have much lower DSOs as they deal primarily in cash.

Importance and Limitations of DSO

• Importance: DSO helps a business gauge how quickly it converts sales into cash, crucial for liquidity and meeting financial commitments.
• Limitations:
  • Industry Variability: Different sectors have unique credit terms, impacting DSO norms.
  • Credit Sales Dependency: DSO is relevant only to companies with substantial credit sales, as it doesn’t account for cash sales.
  • Seasonality Impact: Seasonal businesses may see DSO changes due to sales fluctuations, complicating year-round comparisons.

Days Payable Outstanding (DPO)

DPO measures the average time a company takes to settle its supplier bills, reflecting how it manages cash outflows. Here’s the formula for DPO:

DPO = (Accounts Payable / COGS) * No. of Days

For instance, if Company B has ₹20 lakhs in accounts payable and a COGS of ₹80 lakhs for the quarter (90 days):

DPO = (20,00,000 / 80,00,000) * 90 = 22.5 days

This indicates that Company B takes, on average, 22.5 days to pay its suppliers.

What DPO tells you

• High DPO: A high DPO means the company is taking longer to pay its suppliers, keeping cash on hand longer, which can be advantageous for cash flow. However, consistently delaying payments could harm supplier relationships.
• Low DPO: A low DPO shows timely supplier payments, which helps maintain good supplier relations. Yet, it may also mean the company isn’t fully leveraging credit terms, potentially missing cash flow benefits.

Balancing DSO and DPO

Balancing DSO and DPO is essential for efficient working capital management. Ideally, a company should collect its receivables (DSO) faster than it pays its suppliers (DPO). This ensures sufficient cash is available for operations without excessive reliance on external financing.

For example, consider a hypothetical Company C with a DSO of 60 days and a DPO of 30 days. This discrepancy means that Company C has to pay suppliers before collecting from customers, leading to a cash shortage. To remedy this, Company C could negotiate longer credit terms with suppliers to increase its DPO or enhance its collection process to reduce its DSO.

Importance and Limitations of DPO

• Importance: DPO helps companies analyse their payment and cash management strategies.
• Limitations:
  • Supplier Relations: Extending DPO may strain supplier relationships if payments consistently exceed agreed terms.
  • Industry Benchmarks: Like DSO, DPO should be compared within industry standards, as payment cycles vary across sectors.
  • Ambiguity: A high DPO might indicate efficient cash management or, conversely, potential payment difficulties depending on liquidity and working capital context.

Conclusion

Ravi understood that balancing the timing of cash inflows and outflows is essential for financial stability. A company that collects cash from customers quickly (low DSO) while managing its supplier payments efficiently (high DPO) can maintain a healthy cash flow, allowing it flexibility for growth without financial strain.

As we progress through these chapters, your understanding of asset management, collections, and payments will deepen. Up next, we’ll explore the Capital Employed Turnover Ratio—a key metric for gauging overall business efficiency. As we continue the journey into fundamental analysis, you’ll see how these ratios fit together, building a comprehensive picture of a company’s financial health and potential.