Days Sales Outstanding (DSO) in Valuation and Financial Modeling

Days Sales Outstanding (DSO) is a financial metric measuring the average number of days it takes a company to collect customer payments in cash following sales.

When companies sell products, they often deliver them to customers and accept cash payments later, such as within 30 or 60 days. This policy creates a “lag” between revenue and cash collected, which Days Sales Outstanding measures.

Days Sales Outstanding Definition: Days Sales Outstanding (DSO) is a financial metric measuring the average number of days it takes a company to collect customer payments in cash following sales.

When companies sell products, they often deliver them to customers and accept cash payments later, such as within 30 or 60 days. This policy creates a “lag” between revenue and cash collected, which Days Sales Outstanding measures.

You can calculate Days Sales Outstanding with this formula:

Days Sales Outstanding Formula

For example, if Accounts Receivable is $100, Credit Sales are $400, and you’re looking at an entire year:

DSO = ($100 / $400) * 365 = 91.25 days

This means it takes the company about 3 months to collect cash from customers.

A lower DSO implies a faster collection process, which is desirable since it ensures better cash flow.

A higher DSO signals a slower collection process, which could point to inefficiencies or lenient credit terms, potentially tying up capital and impacting liquidity.

In financial modeling, the DSO metric and projecting Accounts Receivable with DSO tend to be the most useful for startups, small businesses, distressed companies, and any other firm with potential “cash flow issues.”

The DSO metric is also a key component of the Cash Conversion Cycle, used in financial statement and credit analysis.

Files & Resources:

Days Sales Outstanding (DSO) – Slides (PDF)

Monster Beverage – Sample 3-Statement Model with DSO (XL)

Video Table of Contents:

0:48: The Short Answer(s)
2:59: Part 1: Why DSO is “Meh” for Big Companies
5:50: Part 2: Why DSO Can Be More Useful for Startups
9:44: Recap and Summary

Days Sales Outstanding in Financial Models: Why It’s “Meh” for Most Big Companies

The first issue is that most large public companies do not disclose Credit Sales vs. Cash Sales, so, in practice, all you can do is use Net Sales in the formula. It will look something like this:

Days Sales Outstanding (DSO) for Large Companies

The second issue is that DSO adds very little for most big companies because you can already tell if the Cash Collection Time is increasing just by looking at Accounts Receivable / Revenue.

Here’s an example for Monster Beverage, taken from our Core Financial Modeling course:

DSO for Monster Beverage Corporation

DSO here equals AR / Revenue * Days in Year.

We can project the Accounts Receivable balance based on either AR / Revenue or DSO, but in either case, there’s a clear trend toward increasing cash collection times.

No matter what we do, the AR balance keeps increasing over time, reducing the company’s cash flow since an increase in AR makes the Change in Working Capital more negative:

Days Sales Outstanding to Project Accounts Receivable

Days Sales Outstanding for Startups and Small Businesses

The DSO metric can be far more useful here because many of these firms have serious cash-flow problems, such as difficulty invoicing customers or collecting cash.

Also, many of these companies have specific policies about invoice payments, due dates, etc., and you can incorporate these dates into the model by linking them to Days Sales Outstanding.

If a company’s DSO keeps worsening, it may be a sign that it needs to raise more capital than expected or that it needs to change its business policies.

To illustrate, here’s an example of a SaaS company (Sapphire Wolf) taken from our Venture Capital Course.

Initially, the company has 60-day collection times based on 2-year contracts with all upfront payments, which produces the following Cash and Accounts Receivable figures:

60 Day Collection Time for Startup - Cash and Accounts Receivable

However, if the DSO starts creeping up to 3-4-months over the years, the company’s cash flow, Cash, and AR all change substantially.

We can simulate this outcome by modifying the SaaS Billings and AR schedule as follows, changing the percentages to reflect the number of months’ worth of uncollected Billings at the end of each year:

Higher DSO, with Collection Days Increasing from 60 to ~105 Over Time

This change makes a huge impact on the company’s Cash and AR balances, as they now change by ~$8 million by the end of the forecast period:

Days Sales Outstanding Impact on Cash and Accounts Receivable

So, if the Days Sales Outstanding starts “creeping up” like this for a small business or startup, the company might have to re-think its funding needs or change its business policies to encourage faster collection.

How to Improve Days Sales Outstanding

Many companies can optimize their cash flow by reducing their Days Sales Outstanding.

There are a few ways to do this, depending on the company and industry:

1) Offer Incentives – For example, if a customer pays upfront in cash, they get a 10% discount or an offer to save on their next order or renewal. This can encourage faster payments and repeat purchases from customers.

2) Identify Problematic Customers – If some customers are consistently late making their payments, the company could identify them and impose stricter credit terms or additional conditions for doing business with them, such as higher upfront payments.

3) Limit Payment Terms – For example, a company could limit payment windows or installment plans for new or high-risk clients. Follow-up mechanisms, including timely reminders and assertive communication, can also ensure that payments don’t slip through the cracks.

Because of how SaaS billings and accounting work, a software company implementing these strategies could see greatly improved cash flows and even a potentially higher valuation.