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DSO and DPO – What’s the Difference?

Gary Dwyer
GaryDwyer
Product Director
BST Global
Analyzing Days Sales Outstanding (DSO) and Days Payable Outstanding (DPO) can improve one very important financial metric for your AEC firm: cashflow. What It Is 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. How to Calculate DSO Credit SalesA purchase made that does not require the 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 a period of time. 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: Receivables: $2,000,000 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. How to Calculate DPO 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: Payables: $250,000 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. DSO and DPO Target Values 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. Why It’s Important 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. Pay When PaidA contractual clause that stipulates that a contractor is obligated to pay its subcontractors upon receipt of payment from the owner. 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. Conclusion 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! DOWNLOAD GLOSSARY NOW

The Importance of Working Capital for Your AEC Firm

Gary Dwyer
GaryDwyer
Product Director
BST Global
Properly managing your working capital is necessary to ensure your architecture, engineering, and environmental consulting (AEC) firm is able to cover current obligations, improve operational efficiency, and invest in the future growth of your business. What It Is At a high level, working capital is an important financial metric that helps AEC firms assess their short-term financial health. More specifically, it’s how much cash and cash equivalents are available to cover short-term obligations (e.g. salaries, accounts payable, short-term loans, lease payments, etc.). How to Calculate It While there are many different ways to calculate working capital, there are simple calculations you can leverage to demonstrate the current financial state of your firm. Let’s take a look at three common formulas you can use. The basic net working capital formula looks like this: Working Capital = Current Assets – Current Liabilities Another way to measure working capital is by expressing it via the Current Ratio. Current Ratio = Currents Assets Current Liabilities Then there is the Acid Test Ratio, which is similar to the Current Ratio, but excludes certain types of current assets. Acid Test Ratio = (Cash + Cash Equivalents + Short Term Investments + Current Receivables) Current Liabilities To compare, while the Current Ratio includes all Current Assets, the Acid Test only includes cash, cash equivalents, short-term marketable securities, and accounts receivable. Meaning it excludes inventory, prepaid expenses, and deferred income tax. Now that you know how to calculate these simple formulas, let me explain how to analyze the results for each. If you have a negative working capital value (meaning current liabilities exceed current assets), or the Current Ratio has a result below 1.0, this is usually an indication that your firm may not be able to meet its short-term obligations. So, the higher the ratio, the better positioned your company is to meet those obligations. However, if the result is too high, this also means your firm is not efficiently managing its short-term finances (more on this in the next section). While the ideal value of these ratios can vary by industry, typically the result for the Current Ratio should be above 1.2 and the Acid Test Ratio result should be above 1.0. Why It's Important Besides working capital being a representation of liquidity, why is this measurement so important for the success of your AEC firm? Think of a scenario where your firm is already having a difficult time covering its current liabilities – and then, out of nowhere, your firm has an unexpected major project expense or an overrun. How will your firm cover either of these without the necessary cash reserves? Now we’re talking about a recipe for disaster. To top it off, if your firm is consistently unable to properly manage current obligations, it can lead not only to issues in the short-term, but it can also potentially lead to something far more severe: bankruptcy. Now, let’s go back to how you don’t want your firm’s working capital ratio results to be too high for a moment: the reason for this is, it may indicate that your surplus cash reserves are not being used to maximize return for your shareholders. Here’s what I mean: by having too much working capital, it still means your firm isn’t putting its cash to good use. Putting excess cash “to good use” is done by investing those funds in places that will help the company grow. For example, instead of sitting on a large cash reserve, a better option could be to make a large capital purchase that gives your firm the opportunity to expand in the current market, or even a new market. So, whether it’s too much, or too little, your firm should constantly be finding ways to keep working capital at a healthy level. Here are some questions to consider when evaluating your firm’s working capital: Cash: Is your firm investing excess cash reserves for future growth? Accounts Receivable: Can your firm reduce Days Sales Outstanding (DSO) by invoicing quicker or improving its collection process? Short-Term and Long-Term Debt: Is there an opportunity to improve your firm’s liquidity by replacing short-term debt with long-term debt? Trade Payables: Is your firm making the best use of the payment terms agreed with your vendors (e.g. not paying too soon, not paying too late)? Conclusion While there are entire books written on the concept of working capital and the different ways it can be analyzed, the calculations in this post provide a quick, simple method for your firm to evaluate its short-term financial health. When reviewing your company’s current financial state, the best method is to combine these simple liquidity ratios with more in-depth analyses. This gives a more complete picture of your firm’s ability to successfully finance short-term operations and maximize the management of its assets and liabilities. Curious about where you can find other topics to help you analyze the health of your AEC firm? Check out The Ultimate ERP Glossary for AEC Firms, where you’ll find 150 AEC industry terms spanning the entire project lifecycle: from project pursuit, to project delivery, to accounting, and more. Click the link below to download your free copy and learn other important ways to assess projects and keep your firm on track! DOWNLOAD GLOSSARY NOW