Analyzing Days Sales Outstanding (DSO) and Days Payable Outstanding (DPO) can improve one very important financial metric for your AEC firm: cashflow.
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Before I get into how to calculate DSO and DPO, and how the resulting value of each impacts your firm’s cashflow, let’s do a quick refresher on their definitions:
Days Sales Outstanding shows how well your firm is managing its accounts receivable by measuring how long it takes to collect payments owed to your firm.
Days Payable Outstanding shows how well your firm is managing its accounts payable by measuring the average number of days it takes you to pay vendors.
In short, DSO helps your firm see how long it’s taking to collect outstanding payments, and DPO helps your firm see how long it’s taking to pay outstanding bills. And while they address different areas, the information derived from each are equally as important.
Now that you’re caught up on what DSO and DPO means, let’s look at the formula for each.
DSO is calculated by dividing your accounts receivable during a particular time period by the value of your credit sales during that same time period, and then multiplying the result by the number of days in the period. Here’s a quick example:
Credit Sales: $2,800,000
Days in Period: 91 days
DSO Calculation: ($2,000,000 / $2,800,000) x 91 days = 65 days
Your firm should be aiming to have as low of a DSO value as possible because it indicates that you’re doing an excellent job of collecting outstanding debts. A range between the lower 50’s to upper 80’s is a typical value for most AEC firms. But once values start creeping over the upper 80’s, this should be a clear red flag to your firm.
DPO is calculated by dividing your average accounts payable by your daily cost of sales (also sometimes referred to as cost of goods sold or COGS). For example:
Cost of Sales: $1,250,000
DPO Calculation: $250,000 / ($1,250,000 / 365 days) = 73 days
Unlike DSO, you want your DPO value to be higher because it means you can keep cash within your firm for longer. In this case, a range from the mid 60’s to more than 100 would be typical for most AEC firms.
But having a low DSO value, or a high DPO value, doesn’t give you the whole story.
The target values for any firm are influenced by several factors, such as: what industry your firm is in, the type of projects your firm works on, whether that work is public or private, whether your firm is working as a general contractor or a sub-contractor, etc.
So, what may be a target value for one architecture, engineering, or environmental consulting (AEC) firm, may be different for another. For example, if your firm does more private than public work, then the DSO target may be higher as you have room to negotiate more favorable progress payments (e.g. get advance payments), which helps reduce your firm’s DSO.
But as you calculate your 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.
These values cannot be changed overnight – there are processes that need to be put in place and tested in order to see those values start to come down or go up. Depending on which direction the trend moves, it will have a positive or a negative impact on your firm’s available working capital – which is why these calculations are so important to understand. More on this in the next section.
Monitoring the trend of DSO and DPO values provides an insight into how your AEC firm manages its cash. Let’s see just how a positive or negative trend can have an impact.
First off, an increase in your firm’s DSO means you’re financing clients by carrying their debt on your books – this results in a negative impact on your firm’s cash flow since it’s taking longer to collect those payments.
The same impact on your firm’s cash flow happens if your DPO is declining – meaning, cash may be going out sooner than it needs to be. This can be improved by making sure your firm negotiates more favorable payment terms with vendors and pays vendors according to those terms (not paying them earlier than what’s in the agreement), or it can even adopt a Pay When Paid strategy with vendors.
Conversely, a reduction in your firm’s DSO, and an increase in DPO, will lead to improved cash flow for your business. As your firm starts collecting payments more quickly and takes longer to make payments (within reason, of course – you don’t want to ruin the relationship with your vendors!), the amount of cash coming in will exceed the amount going out.
Even the smallest improvements in these factors can have an impact on the amount of working capital your firm has at a given time – so don’t take these lightly, make them a priority.
DSO and DPO are useful formulas for analyzing your firm’s processes (i.e. billing, collections, and payment processes) and can play a direct role in the effectiveness of your cash cycle.
Given the significant role cash plays in successfully running a business, monitoring your DSO and DPO values can help your firm find ways to collect on outstanding bills as quickly as possible, while also watching outflows of cash for vendor payments.
Want to learn other helpful calculations to keep your firm’s finances in check? Check out The Ultimate ERP Glossary for AEC Firms, where you’ll learn 150 terms (along with a whole range of AEC related formulas) that cover the entire project lifecycle. Download your free copy by clicking below!
Good question, Mike! There are varying opinions on whether you should include unbilled work – my position would be to exclude it from the calculation. Reason being, it can potentially cause large fluctuations in your DSO results. Let’s say I have a project that uses milestone billing, depending on the milestone, it could be several months until I can bill for that work – which would have an adverse effect on my results. DSO is just one measure, and I think it should always be used in conjunction with other trends or ratios. For example, including trends on monthly billing and unbilled amounts at the end of each month can be helpful in getting the full story. Also, it’s important to be consistent with how you calculate your DSO (or other ratios) as this will allow you to monitor how you are progressing with the management of your collection process. What is your viewpoint on the DSO calculation?