Days sales outstanding (DSO) measures how quickly a firm collects client payments, while days payable outstanding (DPO) measures how long it takes to pay vendors. Lower DSO and higher DPO generally improve an AEC firm’s cash flow, though ideal values vary by firm and project type. Tracking trends over time is more important than looking at single values, as rising DSO or declining DPO can strain cash flow, while improvements in either metric strengthen working capital.
What Are DSO and DPO?
While days sales outstanding (DSO) and days payable outstanding (DPO) address different areas, the information derived from each is equally important. Before getting into those formulas and how the resulting values impact an architecture, environment or environmental consulting (AEC) firm’s cash flow, here is a quick refresher on some terminology:
DSO shows how well a firm is managing its accounts receivable by measuring how long it takes to collect payments owed to the firm.
DPO shows how well a firm is managing its accounts payable by measuring the average number of days it takes to pay vendors.
Credit sales are purchases made that do not require payment to be made in full at the time of purchase. The full amount can be paid at some point in the future, or smaller regular payments can be made over time.
Analyzing DSO and DPO can improve one very important financial metric for AEC firms: cash flow.
How to Calculate DSO
DSO is calculated by dividing accounts receivable during a particular period by the value of credit sales during that same period and multiplying the result by the number of days in the period, for example:
Receivables: $2,000,000
Credit Sales: $2,800,000
Days in the Period: 91
DSO: ($2,000,000 / $2,800,000) x 91 = 65
An AEC firm should aim to have as low a DSO value as possible because it indicates that it’s doing an excellent job of collecting outstanding debts. A DSO value between the lower 50s and upper 80s is typical for most firms. But once DSO starts creeping into the 90s, it should raise a red flag to your firm.
How to Calculate DPO
DPO is calculated by dividing average accounts payable by the daily cost of sales (also sometimes referred to as cost of goods sold or COGS), for example:
Payables: $250,000
Cost of Sales: $1,250,000
DPO: $250,000 / ($1,250,000 / 365) = 73
Unlike DSO, you want your DPO value to be higher because it means the firm is keeping cash longer. In this case, a DPO value between the mid-60s and 100+ is typical for most AEC firms.
In short, DSO shows how long it takes a firm to collect outstanding payments, and DPO shows how long it takes to pay outstanding bills.
DSO & DPO Target Values
Having a low DSO or a high DPO doesn’t tell the whole story. The target values for any firm are influenced by several factors, such as the industry the firm is in, the type of projects it works on, whether that work is public or private and whether the firm is working as a general contractor or a subcontractor. So, target DSO and DPO values will always vary from firm to firm. For example, if a firm does more private than public work, its DSO target may be higher because it has room to negotiate more favorable progress payments (e.g., receive advance payments) — a factor that impacts a firm’s DSO. However, while calculating a firm’s DSO and DPO values, keep in mind that, while a single value is an important indicator to start paying closer attention, the benefit really comes from tracking these values over time.
DSO and DPO cannot change overnight. Processes need to be put in place and tested to see those values increase or decrease. The direction each value is trending will have a positive or a negative impact on a firm’s available working capital, which is why these calculations are so important to understand.
Why It’s Important
“Pay when paid” refers to a contractual clause that stipulates a contractor’s obligation to pay their subcontractors upon receipt of payment from the owner.
Why DSO & DPO Matter for AEC Firms
Monitoring the trend of DSO and DPO values provides insight into how an AEC firm manages its cash. First, an increase in a firm’s DSO means it’s financing clients by carrying their debt on its books. This results in a negative impact on the firm’s cash flow since it’s taking longer to collect those payments. The same negative impact occurs if DPO is declining — cash may be going out sooner than it needs to be.
A firm can improve by negotiating more favorable payment terms with vendors and paying vendors according to those terms (not paying them earlier than what is agreed) or by adopting a pay-when-paid strategy with vendors. Conversely, a reduction in a firm’s DSO and an increase in DPO will lead to better cash flow for the business. As a firm starts collecting payments more quickly and takes longer to make payments (within reason, of course — so as not to ruin relationships with vendors), the amount of cash coming in will exceed the amount going out.
Improve Your Firm’s Cash Cycle
Even the smallest improvements in these factors can have an impact on the amount of working capital a firm has at a given time, so don’t take them lightly. They should be a priority. DSO and DPO are useful formulas for analyzing a firm’s processes (i.e., billing, collections and payment processes) and can play a direct role in the effectiveness of the cash cycle. Given the significant role cash plays in successfully running a business, monitoring DSO and DPO can help a firm find ways to collect on outstanding bills as quickly as possible while also watching outflows of cash for vendor payments.
