Making a sale, but never collecting the cash from that sale, is the fast track to a cash flow crisis.
Your role as CFO, or as the entrepreneur leading the company, includes being smart about turning those sales, your accounts receivable, into cash as quickly as possible.
Unlike a nice bottle of red wine, receivables don’t get better with age!
Your mission is to put processes and accountabilities in place to make absolutely certain you are collecting receivables as fast as humanly possible.
Time is the enemy… speed is your friend.
DSO is a Powerful Metric
One of the first key performance measures (KPI) I look at when consulting with a company is their DSO. It’s the average number of days of sales that are sitting (and sometimes stuck) in accounts receivable.
It’s a great measure of how well your company is collecting receivables (given the terms you extend to customers).
When I load financial statements into SurvivalWare, one of the first graphs I look at is the DSO graph. And I always look at DSO over a period of time so I can see how the metric is trending.
A Real World Example
Here’s an example from my consulting work that highlights how valuable a visual representation of DSO can be.
The CEO owned a big part of a very successful software company.
He had a very clear picture about he was going to navigate the journey from $6 million in annual sales to $50 million. One part of that plan was bringing some smart, seasoned executives on to the Board of Directors.
He asked me to help create a monthly reporting package to provide the new Board.
He was recruiting some seasoned business executives and he wanted a professional and credible package to help them understand the business and monitor monthly progress against the plan.
The first step in my work was to shine a light on cash flow by looking at how well he and his staff had been managing their accounts receivable.
Here’s a graph of their DSO for the prior year.
You can see from the graph that DSO dipped down to just below 40 days in the May to July period.
The owner had never looked at DSO before. When I showed him this graph, the lights started coming on.
Here’s What Had Happened…
Cash had started to get tight during the first part of the year. You can see that in the graph.
He started pushing on his staff to find out what the problem was. Sales were doing well. The company was profitable. The income statement continued to tell a good story every month.
But cash was in very short supply.
Finally, he looked at an accounts receivable report by customer and it became clear that there had been a slow-down in collecting receivables. He asked the Controller to start calling customers to find out what the problem was and to begin collecting on past due receivables.
The Controller got on it in April and made good progress collecting many of the past due balances.
Once the CEO saw the resulting improvement in collections he backed off and considered the problem solved. Cash flow had improved so he went on to other objectives.
What he did not realize was the Controller, once the cash started flowing in, took her foot off the gas and stopped making frequent calls to customers who owed money. (She really didn’t like “hounding” customers to pay up.)
And as her focus slipped, so did collections.
DSO went right back up like it had done in the first part of the year. You can see the increase in the graph during the latter part of the year.
(Tip: Most accountants don’t like calling customers to collect money from them. So the natural human tendency is to let up after the cash problem gets better. The lesson here is you have to monitor this area very closely.)
Once I showed the CEO the graph, he knew exactly how he could use DSO as a tool for fixing the problem.
He made DSO one of the metrics he monitored every month and he made sure the Controller, and everyone else on the team, knew what their goals and objectives were.
Surprise, surprise! The DSO number stayed down after that.
Compare Your DSO to the Industry
It is also wise to compare your DSO to companies similar to you.
If your DSO was 25 days (meaning there are approximately 25 days of sales that have not yet been converted into cash) but industry practice or your competition is more like 15 days, then you have a problem.
There is something wrong with your process or your execution if you are out of whack with norms in your industry. (It’s also possible you are using payment terms as a competitive weapon – a very risky strategy.)
DSO Helps You Create Reliable Cash Flow Projections
DSO is also a good metric to look at when you are doing cash flow projections.
You want to review the DSO in the resulting accounts receivable balances. This helps ensure you have reasonable assumptions in your projections about both sales and collections.
(Note: I always hook the balance sheet up to my cash flow projections. It is the best way to ensure your projections make sense in the context of their impact on the balance sheet. It puts “guard rails” around your projections and helps prevent any major mistakes in your assumptions.)
Accounts Receivable – A Necessary Evil!
Making the sale to a customer is a win… not collecting the resulting receivable is a ticket to the poor house.
Put the processes and tools in place so you can manage accounts receivable in a way that helps you turn your receivables into cash as quickly as humanly possible.
Monitoring your DSO every month could be the ticket to higher profitability (less bad debt expense) and stronger cash flow.
Philip Campbell’s Blog is dedicated to helping you get the accounting and financial side of your business under control.
Philip Campbell’s Blog is dedicated to helping you get the accounting and financial side of your business under control. Philip also writes a blog at Freedom From Student Loans (http://freedomfromstudentloans.com/) to encourage parents and students to avoid student loans.
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