DSO(Days of Sales ) in Ratio Analysis- How to use?

I was analysing a company, with great revenues and great margins but with no cash!

How is that possible?

Well, it’s quite possible and let’s explore this in-depth.

So, what is the full form of DSO?

DSO stands for days of sales outstanding and is a metric used in financial analysis to compare the effectiveness of a company’s cash collection systems.

Key Takeaways

-DSO is the ratio of Average recivables over sales

-It is used to compare a company’s cash flow

-Higer DSO numbers usually mean poor cash flow situation

– Lower DSO number may also sometimes be due to industry dynamics.

Table Of Contents

Quick Overview

Now, I’ll complete the first statement I made at the start!

A company with healthy revenue and net profit but missing cash, most likely will send an analyst into perplexed trance mode.

However, there can be many reasons for the cash not turning up in the balance sheet but most likely there could two major ones;

  • Your company in question is not able to collect the cash
  • May be the company use using the some creative accounting tactic to inflate profits.

Both of which, are some serious issues and If I was the analyst would raise my eye brows!

🤨 Face with One Eyebrow Raised Emoji

Under ideal, happy and honest conditions the company should sell the goods and collect cash!

How difficult is that to do?

However, lets be honest, not all thieves are usually convicted of fraud, because not all tactics might attract the attention of law enforcement.

DSO in simple language trying to figure of the amount of sales done by the company is actually still not collected in cash.

Allen Aravindan

DSO Formula and Use

Now before I start hammering this article with the DSO formula, and getting lost in the calculation.

First, lets understand the linkages of various accounts in the balance sheet and income statment.

  • Any sales done in cash goes to – Balance sheet cash
  • Secondly sales not done in cash goes to-Accounts recievable in balance sheet.

Ofcourse both are going to the balance sheet and in the asset side.

Accounts Recivable

So, I am not really worried about the sales that is collected in cash, but I am definetly worried about the one which will be collected in the future.

The future is the future, what is today matters more to analyse

Analyst Conversation

DSO Formula

So, I know want to find out how much on an average is the;

  • Sales not collected in cash versus the total sales made

Hence, just a proportion to begin with.

receeve — 4 Ways to Reduce your Company's Days Sales Outstanding (DSO)
DSO Formula

Firstly, don’t worry too much about the word credit sales, because that means just sales /revenue.

In conclusion, it means how much is accounts receivable a proportion of sales which gives us a % and then multiply that with 365 days.

Essentially we are converting the percentage into a different format of days.

Quick Example here:

Let’s say I was running a business and I sold $5000 worth of goods. Which generated cash of $2500.

So, applying the proportionate logic here, simply means 50% is not collected.

Converting into days: 50% of 365 = 182 Days.

How simple was that?

How to interpret the ratio?

Now, merely calculating the DSO and saying that we found the mole.

Firstly, is counting your eggs before they hatch!

Secondly, not living up the to the sherloc home standards!

Sherlock Holmes GIFs | Tenor

So, then how do we really interpret?

  • Which industry does the company operate on?
  • What is the history of of the company’s DSO?
  • Is there a significant change over time?

These questions are important, because we do want to ignore the bad ones but not lose out on the stars.

Here is a simple example, to show why the context is so important.

Look at the debtor days, which is the same as DSO for godrej versus DLF.

Notice, that in real estate industry DSO can’t be expected to be zero, but hovers around 40-50 range.

Moreover let’s look at the IT services industry.

So, are you expecting the DSO to be zero?

Infosys Versus TCS

The numbers do suggest, that even service industry can have some lag in cash collection but are these companies bad?

Ofcourse not, in fact infosys and TCS are the sachin tendulkar and virat kohli’s of the stock market!

Is there a good or bad DSO?

My plain answer is no because good and bad are relative terms, which we have already discussed above.

Look, at the DSO numbers of these two reasobly good companies in avaiation in India.

So, under the good and bad scheme, these DSO numbers shold be excellent right?

However aviation industry works on zero credit system, which results in the appearance of good work.

Last i’ll conclude this section by saying, that industry and peers is the most important aspect of ratios.

Real World Examples

Now, let me jump into some hardcore analysis without the bits and pieces approach.

Hot Dog Meme Contest | NHDSC

So, this is my objective;

  • I want to invest a large sum of capital to generate capital appreciation.

That’s a sophisticated way of a investment banker saying;

“Show me the money”

  • Second, I want to invest in high cash rich and cash flow companies.
  • Finally, I want them to have a consistent past.

Now, that’s a real problem to solve, which needs some good analysis.

Step 1: Filter the Sectors

Since, I want to invest in cash ruch and companies with consitent cash flows.

So I have to look at the correct sector right.

Hence the sectors with cash rich traits are as follows to name a few:

  • FMCG
  • Aviation
  • Consumer electronics
  • Automobiles
  • E commerce

Now, don’t over think this because I just used my own imagination to find business’s which get paid instantly.

However, we can’t really analyse all the sectors, so let’s focus on consumer durables and Aviation.

Step 2: Filter the data

Now,it’s time to filter the data and come to some names with good DSO numbers and high cash flows.

I have downloaded and created a template for this analysis, which you can use.

So, in case of the consumer durable segment, blue star clearly is the winner.

The company has the highest 3 Year cash flows and lowest days of sales outstanding.

An insight here is that companies with higher running cashflows, also automatically have lower DSO.

Moreover the situation is not very different in aviation too.

Interglobe(Indigo airlines), has the highest 3 year cash flows, with lowest DSO.

Even if the industry already has the trait of lower DSO.

Step 3: Finalise 2 Comapnies for further analysis

Now, its foolish to stop at DSO and free cash flow.

We need to still pick the names, but its not necessary that we will pick blue star and indigo in their respective sectors.

There could be multiple other factors, which are not visible for now.

For example: On further analysis, this is what complicates matters further

Moreover, now the interesting scenario that is created is:

  • Spicejet has a better sales growth rate for last three years, compared to Interglobe
  • Also, Interglobe has high debt versus spicejet which has almost zero debt.
  • Lastly, an exceptional case of Jet freight where it has shown high sales growth rate.

In conclusion, without extending this discussion the point to be made is that you should take ratios with a spoon of salt.

Exceptional Cases

These are industries which are bound to have higher DSO’s, because of the business dynamics.

For example: Construction or infra based companies, which have a long wait time.

Moreover, there is also the additional element of accounting principles,which can make these ratios inflate.

For example; construction business’s don’t use the common revenue recognition method, instead they might use methods like

  • Percentage completion method
  • Cost recovery
  • Completed Contract method

Which, by the way is unlike saying that a person paid me cash today or not.

How on earth can we use that principle, when the construction of a highway might take 5 years to complete?

So the principle used in such cases, relates to the completion of the project itself.

Now that would naturally show higher sales and recievables which doesn’t mean the company is bad.

Conclusions

I’ll conclude this very long discussion, by saying that small things matter in financial analysis.

In my intial years as an investor and analyst, I was tempted to conclude things too quick.

However, what I have understood with expereince,is that common sense element in analysis should 95%, along with 5% of tools like ratios.

You may want to check out my financial analysis course and also another article related to inventory scams.

Ciao!

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ALLEN ARAVINDAN,CFA

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