How to Reduce DSO

Days Sales Outstanding (DSO) is a critical financial metric. It measures the average number of days it takes for your business to collect payment after a sale. The lower your DSO, the faster you collect payments and the healthier your cash flow.

Reducing DSO is crucial for your business's financial well-being. Collecting payments quickly gives you more cash to fund operations, invest in growth opportunities, and maintain a stable financial position. Conversely, high DSO means your money is stuck in unpaid invoices, limiting your liquidity and potentially risking your business. Reducing DSO can improve your cash flow, reduce the need for borrowing, and create a more resilient financial foundation for your company.

To calculate DSO, use this formula:

DSO = (Accounts Receivable / Total Credit Sales) x Number of Days in the Period

For example, if your accounts receivable is $100,000, your total credit sales for the last 90 days were $500,000, and you're measuring DSO for that 90-day period, your DSO would be:

DSO = ($100,000 / $500,000) x 90 = 18 days

In this case, it takes an average of 18 days for your business to collect payment after a sale.

Benchmarking Your DSO

You first need to establish a realistic target to reduce your DSO. Start by benchmarking your current DSO against industry averages. This will give you a clear idea of how your business compares to others in your sector. You can find industry benchmarks through trade associations, financial publications, or consulting with finance professionals.

DSO can vary significantly between industries. For example, businesses in the construction industry often have higher DSO due to the nature of their projects and payment terms. In comparison, retail companies typically have lower DSO because of immediate payment processing. 

Compare, Assess, and Set Targets

When comparing your DSO to industry benchmarks, look at data specific to your sector for an accurate comparison.

Next, assess your business cycle and cash flow needs. Consider your typical payment terms, the time it takes to deliver goods or services, and your monthly expenses. Based on these factors, determine a DSO target that allows you to maintain a healthy cash flow while still being competitive within your industry.

For instance, if your industry's average DSO is 45 days, but your business has higher operational costs and shorter payment terms, you may set a lower DSO target of 30 days to ensure you have the cash flow needed to meet your obligations.

Remember, your DSO target isn't set in stone. As your business grows and evolves, your cash flow needs may change. Review and adjust your DSO target to align with your business goals and financial requirements.

By benchmarking your DSO against industry averages and considering your unique business needs, you can set an appropriate DSO target that helps you improve your cash flow and maintain a solid financial position.

Strategies to Reduce DSO

Invoice Management

Optimizing your invoice management process is one of the most effective ways to reduce your DSO. First and foremost, always send out invoices promptly after delivering goods or services. Implement a standard invoicing schedule and stick to it consistently. Consider setting a goal to send invoices within 24-48 hours of delivering your product or service.

When creating invoices, include the due date, accepted payment methods, and late penalties. Use bold or colored text to highlight key information, such as the total amount due and the payment deadline. Consider offering multiple payment options, such as credit card, ACH transfer, or e-check, so it's easier for customers to pay on time.

Consider automating your invoicing process with accounting software or invoicing tools. Doing so reduces the risk of human error, ensures consistency, and saves time. Plus, many invoicing tools offer features like automatic payment reminders and online payment options, which can further speed up the collection process. Some tools even allow you to set up recurring invoices for regular customers, saving you even more time in the long run.

Credit Policies

A robust credit policy is crucial for managing customer credit risk and reducing DSO. Before extending credit:

• Conduct thorough credit checks on new customers.
• Look at their payment history, credit scores, and financial stability to assess their creditworthiness.
• Consider using a credit reporting agency to comprehensively view a customer's credit profile.

Establish clear credit limits based on each customer's credit profile and your business's risk tolerance. Regularly review and adjust these limits as needed. For example, if a customer consistently pays on time, you may choose to increase their credit limit. On the other hand, if a customer's payment habits become erratic, you may need to lower their limit or even revoke their credit privileges.

Communicate your credit policies to customers proactively so they understand your expectations and the consequences of late payments. Include your credit terms in your contracts and on your invoices. Consider sending a welcome packet to new customers outlining your credit policies and procedures.

For high-risk customers or those with a history of late payments, consider requiring upfront payments or offering shorter payment terms. On the other hand, you can extend more favorable terms to customers with a strong payment record to build loyalty and encourage timely payments. Monitor your customers' payment behavior regularly and adjust your approach as needed.

Payment Terms

To set suitable payment terms, start by evaluating what you currently have and comparing it to industry standards. If your terms are longer than the norm, consider shortening them to encourage faster payment. For example, if your current terms are net 60, consider moving to net 30 or even net 15.

Offer incentives for early payment, such as a small discount for invoices paid within a specific timeframe. For example, you might offer a 5% discount for invoices paid within 10 days of issuance. This can motivate customers to prioritize your invoices and pay more quickly. Be sure to communicate these early payment discounts on your invoices and payment terms.

On the flip side, enforce penalties for late payments. Communicate these penalties in your payment terms and follow through consistently. Late fees can be a percentage of the invoice or a flat fee. For example, you might charge a 1.5% late fee per month on overdue invoices. Check local regulations to ensure your late payment penalties comply with legal requirements.

Another strategy is to require partial payments upfront for large projects or orders. This can help you manage your cash flow and reduce your risk exposure. For example, you might require a 50% deposit before starting work on a project, with the remaining balance due upon completion.

Finally, consider offering payment plans for customers struggling to pay their invoices in full. By breaking the total amount due into smaller, more manageable payments, you can help customers get back on track while still collecting.

Customer Communication

Proactive communication with customers is essential for managing DSO effectively. Don't wait until an invoice is past due to contact them. Instead, make it a habit to communicate regularly with customers about their payment statuses and any potential issues they might face.

Consider sending friendly payment reminders before the due date to encourage timely payment. You can automate these reminders through your invoicing software or send them manually via email. Be sure to include a copy of the original invoice and clear instructions on how to pay.

If a payment becomes past due, contact the customer promptly to inquire about the status of the invoice. Use a friendly, professional tone and try to understand if any issues prevent them from paying. By opening the lines of communication, you can work together to find a solution and get the invoice paid.

In some cases, customers may have ongoing issues that affect their ability to pay on time. In these situations, consider setting up regular check-in calls or emails to discuss their account status and work together to find ways to streamline the payment process.

Customer communication aims to build solid relationships and work collaboratively to ensure timely payment. By being proactive, understanding, and solution-oriented, you can improve your chances of getting paid on time and reducing your DSO.

Customer Segmentation

Not all customers are created equal when it comes to payment behavior. That's where customer segmentation comes in. By segmenting your customers based on factors like payment history, credit risk, and industry, you can tailor your payment terms and collection strategies to encourage faster payment.

Start by analyzing your customers' payment data to identify patterns and trends. Look for customers who consistently pay late or have a history of disputes. These customers may require more stringent payment terms or additional monitoring to ensure timely payment.

On the other hand, customers with a strong payment record may be candidates for more favorable terms, such as longer payment windows or higher credit limits. By rewarding good payment behavior, you can build loyalty and encourage these customers to continue prioritizing your invoices.

Consider segmenting customers by industry as well. Some industries, such as construction or healthcare, may have longer payment cycles due to the nature of their business. For these customers, you may need to adjust your expectations and develop industry-specific strategies for managing DSO.

Another approach is to segment customers by risk level. High-risk customers may require additional security measures, such as deposits or personal guarantees, before extending credit. Low-risk customers, on the other hand, may be eligible for more flexible terms and higher credit limits.

By tailoring your approach to different customer segments, you can develop targeted strategies for reducing DSO and improving cash flow. Just be sure to regularly review and update your segmentation criteria to ensure they remain relevant and effective over time.

Regular Monitoring and Adjustments

Reducing DSO is not a one-time effort. It requires ongoing monitoring and adjustments to ensure your strategies remain effective as your business and customer base evolve.

Start by establishing a regular schedule for reviewing your DSO performance. This may be weekly, monthly, or quarterly, depending on your business's size and complexity. Use this time to analyze your DSO trends, identify improvement areas, and track your current strategies' effectiveness.

If your DSO is consistently higher than your target, it may be time to adjust your policies and practices. This could include tightening credit policies, shortening payment terms, or increasing collection efforts.

On the other hand, if you see that certain strategies are working well, consider doubling down on those efforts. For example, if customers respond positively to early payment discounts, you may want to expand or enhance those incentives.

It's also important to regularly review and analyze patterns in customer disputes. If you notice that certain types of disputes are occurring frequently, take steps to address the root cause. This may involve providing more detailed documentation on invoices, clarifying contract terms upfront, or improving communication with customers throughout the sales process.

Another aspect of monitoring is staying up-to-date on industry trends and best practices. Attend industry conferences, read trade publications, and network with other finance professionals to learn about new strategies and technologies for managing DSO.

Regularly monitoring your DSO performance and making proactive adjustments can ensure that your strategies remain effective and aligned with your business goals over time.

Technological Solutions

In today's digital age, leveraging advanced accounts receivable (AR) software and automation can significantly streamline your invoicing and collections processes, ultimately reducing your DSO.

AR automation tools can help you automate repetitive tasks, such as invoice generation, payment reminders, and customer follow-ups. Automating these processes saves time, reduces errors, and guarantees a more consistent, professional approach to collections.

Many AR software solutions offer features like customizable invoice templates, online payment portals, and automatic payment processing. These features make it easier for customers to pay on time and reduce the administrative burden on your team.

Some AR tools also offer advanced analytics and reporting capabilities. By providing real-time visibility into your AR performance, these tools can help you identify trends, spot potential issues, and make data-driven decisions to optimize your collections process.

When choosing an AR software solution, look for one that integrates seamlessly with your existing accounting and ERP systems. This will ensure a smooth data flow and minimize the need for manual data entry.

Implementing AR automation can require an initial investment of time and resources. However, the long-term benefits – such as reduced DSO, improved cash flow, and increased efficiency – can far outweigh the costs. By embracing technological solutions, you can position your business for success in an increasingly digital world.

Reduce DSO Like Kea

Kea, a conversational AI company, successfully reduced its DSO by 13 days after implementing Tabs, an automated invoicing and AR management platform. With Tabs, Kea could automate complex invoice calculations based on commissions, flat fees, and volume data, saving hours of manual work each month.

The integration between Tabs and Stripe also enabled Kea to automatically charge customers paying by card, leading to increased credit card usage and faster payment times. Additionally, Kea's customers appreciated the improved billing experience, which provided a clear breakdown of charges by store location.

By streamlining their invoicing and AR processes with Tabs, Kea reduced DSO, improved customer satisfaction, and freed up time for their finance team to focus on strategic initiatives to support the company's growth.

Concluding Thoughts

Reducing DSO is a critical component of effective financial management. By implementing the strategies and technologies discussed here, you can take control of your accounts receivable and improve your business's liquidity and financial health.

Optimizing your invoicing process, strengthening your credit policies, and setting clear payment terms are all essential steps in reducing DSO. Proactive customer communication, segmentation, and regular monitoring and adjustments can further enhance your efforts.

Embracing technological solutions, such as AR automation software, can also significantly improve your collections process and reduce DSO. As the Kea case study demonstrates, the right tools can save time, improve accuracy, and enhance the customer experience.

Ultimately, reducing DSO is about more than just improving your bottom line. It's about building strong customer relationships, fostering trust, and creating a solid foundation for long-term success. By prioritizing DSO reduction, you can position your business for growth and resilience in the face of any challenge.

Remember, reducing DSO is an ongoing process that requires continuous monitoring, adjustment, and improvement. By staying proactive, embracing best practices, and leveraging the right tools and strategies, you can unlock the full potential of your accounts receivable and set your business up for lasting success. Ready to get started? Schedule a demo today.