Accounts Receivable Days: Definition, Formula, and How to Calculate It?

From the time a business makes a sale on credit, till they receive payment from the customer, the bill amount is held under Accounts Receivable on the balance sheet. The average number of days it takes for a business to collect this payment and convert their accounts receivable into cash is known as Accounts Receivable Days, or DSO.

This metric helps businesses gain an overview of their cash flow and understand if they are equipped to meet their near and long-term expenses. It also helps understand if a business has efficient collections and sound credit policies.

For example, if a business has a high AR days number, it might suggest that they have lenient credit terms and are not collecting proactively. On the contrary, a very low AR days number might indicate that everything is going well and the business has the room to open up their credit policies a little bit to attract more business.

In this blog, we will learn in depth about accounts receivable days, how to calculate it, its interpretation, and strategies businesses can apply to bring it down.

What is Accounts Receivable Days?

Accounts Receivable Days, also known as Days Sales Outstanding (DSO), is a financial metric that indicates the average number of days it takes for a company to collect payments from its customers after a sale has been made. This metric is an essential component of a company's working capital management and provides insights into its liquidity and efficiency in managing receivables.

By calculating accounts receivable days, businesses can understand how efficient their order-to-cash process is. It also helps in planning for short-term expenses, as AR days provide insights into the liquidity of a company’s pending payments.

Importance of Accounts Receivable Days

Understanding the importance of AR days can provide valuable insights into the efficiency and effectiveness of a company’s credit and collections policies. Let’s take a look.

1. Cash flow management

One of the primary reasons Accounts Receivable Days is important is its direct impact on cash flow. Cash flow is the oxygen of any business, and efficient cash flow management ensures that the company has enough liquidity to meet its operational needs. 

A high DSO indicates that cash is tied up in receivables for a longer period, which can strain the company’s cash flow and limit its ability to invest in growth opportunities or meet its short-term obligations.

2. Credit policy effectiveness

Accounts Receivable Days can serve as a barometer for the effectiveness of a company's credit policies. By monitoring AR Days, businesses can assess whether their credit terms are too lenient or too strict.  A high number might suggest that credit terms are too generous or that the creditworthiness of customers is not being adequately assessed. 

Conversely, a very low number might indicate that credit terms are too stringent, potentially deterring sales. Balancing these aspects is crucial for maintaining healthy customer relationships and ensuring sustainable sales growth.

3. Financial health indicator

AR days is a valuable indicator of a company’s financial health. Consistently high accounts receivable days can be a red flag for investors and stakeholders, signaling potential problems with collections, customer creditworthiness, or the company’s financial stability. 

It can also affect the company's ability to secure financing, as lenders may view high AR days as a risk factor. On the other hand, a lower number is generally seen as a positive sign, indicating efficient operations and a strong cash position.

4. Benchmarking and performance evaluation

Accounts Receivable Days is often used to benchmark a company's performance against industry standards or competitors. This comparison can help identify areas for improvement and provide insights into how well the company is managing its receivables relative to its peers.

By analyzing trends over time, companies can also evaluate the effectiveness of their strategies and make informed decisions to enhance their credit and collection processes.

5. Impact on profitability

Efficient management of accounts receivable can have a direct impact on a company’s profitability. Reducing AR days can lead to lower working capital requirements, thereby freeing up resources that can be reinvested into the business. 

It also helps in minimizing the time between making a sale and collecting payment, which reduces the risk of bad debts and improves overall profitability. Businesses that effectively manage their receivables can thus enhance their financial performance and competitive advantage.

Formula and Calculation of Accounts Receivable Days

Accounts Receivable Days can be calculated by dividing the total Accounts Receivable in a given time period by the total credit sales and then multiplying it by the number of days during that period.

Formula: 

Accounts Receivable Days = (Accounts Receivable / Total credit sales) * Number of days

Where:

• Accounts receivable: The total amount of money owed to the company by its customers for sales made on credit.
• Total credit sales: The total sales made on credit during a specific period.
• Number of days: The number of days in the period being analyzed (typically 365 days for a year).

Example

Let’s say a company, ABC, made total sales of $10 million in a period of 365 days and out of this total revenue, $7 million was on credit. At the end of the year, it had a pending Accounts Receivable balance of $2 million. So,

Total credit sales = $7,000,000

Accounts Receivable = $2,000,000

Number of days = 365 days

Accounts Receivable Days = ($2,000,000 / $7,000,000) * 365 = 0.285 * 365 = 104.02 

So, the Accounts Receivable Days for company ABC is 104.02 days.

Note: Do not calculate the data using the total revenue, and always use the total credit sales to get accurate data.

Multiple ways to Interpret Accounts Receivable Days Number

Accounts Receivable Days (DSO) is a critical metric for understanding how efficiently a company is managing its accounts receivable. Here’s how to interpret different DSO values:

Low DSO

A low DSO indicates that a company is efficient in collecting its receivables. This means that customers are paying their invoices quickly, which has several positive implications:

• Strong cash flow: Quick collection of receivables ensures a steady cash flow, enabling the company to meet its short-term obligations and invest in growth opportunities without relying heavily on external financing.
• Effective credit policies: A low DSO suggests that the company's credit policies are effective, with stringent credit checks and efficient collections processes in place.
• Customer creditworthiness: It may indicate that the company has a customer base with good creditworthiness, which reduces the risk of bad debts.

However, if DSO is too low, it might indicate overly stringent credit terms that could deter potential customers, possibly impacting sales negatively.

High DSO

A high DSO suggests that the company is taking longer to collect its receivables, which can have several negative consequences:

• Cash flow issues: Delays in collecting receivables can lead to cash flow problems, making it difficult for the company to cover operational expenses and invest in business growth.
• Ineffective credit policies: High DSO may point to lax credit policies, where credit is extended to customers with poor creditworthiness, or inefficiencies in the collections process.
• Increased risk of bad debts: The longer receivables remain unpaid, the higher the risk that they may become uncollectible, leading to bad debts that can impact the company’s profitability.

A consistently high DSO is a red flag for investors and stakeholders, as it may indicate underlying problems with the company’s financial health and operational efficiency.

Industry Comparisons

Interpreting DSO also involves comparing it with industry averages. Different industries have varying credit terms and collection practices, so what is considered a good or bad DSO can differ significantly:

• Industry norms: A DSO in line with or better than the industry average typically indicates that the company is performing well in managing its receivables.
• Competitive benchmarking: Comparing DSO with direct competitors can provide insights into whether the company’s credit policies and collections processes are more or less effective than its peers.

Historical Trends

Analyzing DSO trends over time within the same company can reveal important insights:

• Improving DSO: A decreasing DSO trend suggests that the company is improving its receivables management, possibly through better credit policies or more efficient collections processes.
• Worsening DSO: An increasing DSO trend could indicate deteriorating credit control, potential cash flow problems, or changes in customer creditworthiness.

Balancing DSO

While a low DSO is generally favorable, it’s essential to balance it with other business objectives:

• Sales growth: Extremely stringent credit terms might reduce sales. Companies need to find a balance where they can maintain healthy receivables turnover without compromising sales growth.
• Customer relationships: Maintaining good relationships with customers often involves offering reasonable credit terms. Striking a balance between maintaining customer satisfaction and ensuring timely collections is key to long-term business success.

Good and Bad Accounts Receivable Days Number

A good or bad account receivable day number is very subjective and varies widely from one industry to another. For example, oil and gas extraction companies have an average AR days of about 110. On the other hand, for scientific research and development services, it's 70.8. So, if two companies in different industries compare their numbers, they won’t get an accurate picture of their balance sheet health.

That’s not it, these numbers can also vary within the same industry based on the strategies that are being used. For example, if a company offers a 30-day period for payment after sale, its AR days is expected to be lower than those of a company offering a 60-day payment period. 

In this case, a higher DSO is not bad as it is being used to bring in more sales and incentivize customers to purchase from them.

5 Strategies to Reduce Accounts Receivable Days for a Business

Reducing Accounts Receivable Days (DSO) is essential for improving cash flow, financial stability, and operational efficiency. Here are five strategies that businesses can implement to achieve this goal:

1. Implement clear credit policies

Having well-defined credit policies is crucial for managing accounts receivable effectively. Businesses should conduct thorough credit checks on new customers before extending credit, ensuring they assess the customer’s creditworthiness and reduce the risk of late payments. Setting appropriate credit limits based on the customer’s financial health and payment history is also essential. 

Regular reviews and adjustments to these limits can help maintain control over receivables. Additionally, businesses should clearly communicate payment terms to customers, considering shorter payment cycles, such as net 30 days instead of net 60 days, to expedite collections.

2. Streamline invoicing processes

Efficient invoicing can significantly reduce the time it takes to receive payment. When invoices are sent immediately after the delivery of goods or services, can prevent delays in payment. Ensuring invoices are accurate and detailed helps avoid disputes and delays caused by billing errors. 

Businesses can utilize electronic invoicing systems, which further enhance efficiency by speeding up the invoicing process, reducing mailing times, and providing customers with an easy way to process and pay invoices.

3. Offer incentives for early payment

Offering incentives for early payment can motivate customers to pay their invoices sooner. Businesses can introduce discounts for early payments, such as a 2% discount if the invoice is paid within 10 days. These incentives should be clearly communicated and prominently displayed on invoices. 

Implementing a tiered discount structure, where the discount percentage decreases as the payment period extends, can also encourage quicker payments while balancing the cost of discounts with the benefit of improved cash flow.

4. Strengthen follow-up and collection procedures

Consistent and proactive follow-up on outstanding invoices is essential for reducing accounts receivable days. Implementing a systematic reminder system, such as automated email reminders or phone calls, can keep customers informed about upcoming and overdue payments. 

Assigning dedicated staff to monitor and manage accounts receivable ensures timely follow-ups and personalized communication with customers. For persistent late payers, businesses may need to implement stricter collection procedures, including late fees or involving collection agencies if necessary.

5. Utilize technology and automation

Leveraging technology and automation can streamline accounts receivable processes and improve efficiency. Adopting accounts receivable management software can automate invoicing, payment reminders, and follow-ups, reducing manual efforts and errors. 

Integrating these systems with the company’s accounting software can provide real-time visibility into receivables and enhance reporting capabilities. Additionally, offering online payment options, such as credit card payments or electronic funds transfers (EFT), can make it easier for customers to pay invoices quickly, reducing the overall DSO.

Bottom Line

Accounts receivable days, or DSO, is a crucial metric that every business should track and analyze to get an understanding of the effectiveness of their credit policies and collection process. It can also help businesses understand where they stand with respect to their competition by comparing their numbers with industry averages.

FAQs

1. Is DSO and Accounts Receivable Days the same?

Accounts receivable days and DSO represent the same metric. They measure the average number of days it takes for a company to collect payment after a sale has been made on credit. By dividing accounts receivable by total credit sales and multiplying by the number of days in the period, it reveals how effectively a company manages its accounts receivable.

2. Why is Accounts Receivable Days important?

Accounts receivable days is crucial, as it directly impact cash flow, financial health, and liquidity. A lower DSO typically signifies efficient collection processes and healthier cash flow, while a higher DSO can indicate potential cash flow problems, ineffective credit policies, or challenges in collecting payments promptly.

3. How Can a Business Reduce its Accounts Receivable Days?

Businesses can reduce Accounts Receivable Days by implementing clear credit policies, streamlining invoicing processes, offering incentives for early payment, strengthening follow-up procedures, and utilizing technology for automation. These strategies help expedite payments, improve cash flow, and enhance overall financial management.

4. What does a high Accounts Receivable Days indicate?

A high Accounts Receivable Days (DSO) suggests that a company takes longer to collect payments from its customers. This can lead to cash flow challenges, increased risk of bad debts, and potential strain on financial resources. It may also indicate inefficiencies in credit management, collections processes, or issues with customer creditworthiness.

5. What are net days in accounts receivable?

Net days in accounts receivable refers to the agreed-upon period within which a customer is expected to settle their outstanding invoice after the goods or services have been delivered. It represents the number of days from the invoice date that payment is due without incurring penalties or interest charges.