Credit Risk Management

Why DSO Benchmarks and Benchmarking are Still Important

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Advertising firms such as Clear Channel, whose billboard is shown above, have high DSOs. Clear Channel has an avgerage DSO of 98.80 days.

With companies becoming more aggressive in recognizing revenue, widening credit terms and selling globally, the calculation for determining when they get paid has never been more important.

Faro Technologies, Inc. is a $190 million scientific and technical instruments manufacturer based in Lake Mary, Florida, a suburb of Orlando.  The company is a manufacturer and marketer of software-based, three-dimensional measurement and imaging systems, according to company information.  Its principal products include the FaroArm, FARO Laser ScanArm and the FARO Gage. 

Like many high-tech manufacturers, Faro sells its products through a direct sales force that, according to the company, is located in "many of the world's largest industrialized countries."  But, unlike other companies in the high-tech arena, Faro grants extremely favorable credit terms of anywhere from 30-90 days before payment is due, according to information obtained in the company's SEC filings. 

Little wonder that in 2009, the company had a days sales outstanding, or DSO, average of 106.12 days almost 36 days over the industry benchmark of 70.32 days, according to the 2009 Credit Standards Index (CSI), an index of over 2,000 publicly-traded companies in 70 industries. 

What's more, Faro's operating cash as a percent of revenue, one of the five factors in the CSI, was a paltry 6 percent in an industry that averages 13 percent.  Some 63 percent of Faro's sales are international, according to the company.

The case of Faro Technologies and the relationship of its high DSO to its liberal payment terms underscores the financial relevance even today of the simple ratio that has served as key performance indicator in the accounting and finance world for everything from receivables effeciency, revenue recognition, credit and collections standards and the general health of a company.

The days sales outstanding ratio is critical because it attaches a time element to the all-important relationship of revenue to operating cash.  This one simple ratio answers one of the financial world's most important questions: How long does it take a company to receive cash for revenue previously recognized?  The answer to that question, in turn, provides key insight into the organizational structure and managerial standards of a company. 

In the technical world of accounting, DSO has remained a stalwart due to its effectiveness, perhaps more than any other ratio, in cross referencing one of the key features of the balance sheet, the accounts receivable, with the key feature of the income statement, sales revenue.

Dr. Charles W. Mulford, professor of accounting and finance at The Georgia Institute of Technology in Atlanta, and an expert on financial statement analysis, said in an exclusive interview with CreditPulse, that he doesn't see the importance of DSO changing anytime soon "because it very directly relates sales to how long it takes to collect those sales," says Mulford.  "It gives it a time element so it's easy to conceptualize what it means."

Companies large and small recognize the value of DSO.  Illinois Tool Works, Inc., a $14 billion machinery and tool manufacturer with 875 operations in 54 countries around the world, is so vast and decentralized that it doesn't require its businesses to provide detailed information on operating results, according to its annual 10K filing.  Instead, the company's corporate management collects data on what it calls "a few key measurements."  Days sales outstanding is one of them. 

Many in the field of credit management, those largely responsible for managing DSO, also recognize the importance of the ratio as a way of measuring credit department performance, as evidenced by a survey conducted in 2007 by an industry trade publication.  DSO was the overwhelming pick out of 38 most utilized benchmarks, as 30 percent polled said DSO was the most effective benchmark followed next by past due percentage at 14.3 percent.

However, despite its wide spread use and longetivity, the DSO ratio is not without some detractors.  The Credit Research Foundation (CRF), a non-profit credit think tank located near Washington D.C., has claimed in recent years that DSO is ill-suited for guaging the performance of the credit function because of possible distortions created by fluctuating sales figures.  Also, they say, the ratio doesn't make allowances for extended credit terms.  As a result, CRF has pushed several far-reaching alternatives to DSO such as the Collections Effectiveness Index (CEI), best possible DSO and one exotic measurement called the count-back method.

But CSI research shows that sales fluctuation, at least on a quarterly basis, is insignificant for the majority of publicly-traded companies in most industries even those that are economically sensitive such as construction.  Consider the 2009 quarterly sales figures for Fastenal Company, a $2 billion industrial and construction wholesale supplier based in Winona, Minnesota.  Fastenal's sales were steady throughout the year, with only a 3 percent deviation between quarters.  First and third quarter sales and second and fourth quarter sales were virtually identical.  The larger sales deviation came from year-to-year, not quarter-to-quarter but DSO is rarely calculated on an annual basis except for benchmarking purposes.

Critics contend that alternatives to the established DSO calculation are used largely as a means of performance enhancement rather than reporting accuracy.  Regardless, none have come close to gaining acceptance in the mainstream world of accounting and finance. 

DSO industry averages (see accompanying chart) reflect a wide range of operational, structural, managerial, economic and credit nuances.  For instance, at first glance, export sales would seem to be a principal reason for a higher DSO since many export-oriented industries -- oil and gas equipment, software technology, communications equipment and scientific and technical instruments -- have DSO averages in the 60-70 days range.  Yet, the semiconductor industry, which encompasses 89 companies in the CSI, exports 70 percent of its sales but has an industry DSO benchmark of only 41.56 days.

Meanwhile, the advertising and marketing industry has one of the lowest export sales percentages, yet has by far the highest DSO industry average.  CreditPulse research has found that a strong relationship exists between cost-of-revenue, the variable or direct costs associated with a company's sales, and the DSO of a company or industry.  Industries that bear heavy revenue generating costs, such as lumber and wood products, various mining related industries, industrial manufacturing, trucking, etc., seem to have much less patience in waiting for their cash.

Regardless of company or industry, higher DSO averages mean less cash in the short-run when most companies need it the most.  Besides as Dr. Mulford points out, "It's not a sign of strength when you see days sales start going up in a company whether it's by design (an increase in net terms) or it's just by having trouble collecting."  As Dr. Mulford emphasizes, "they are just trying to boost sales."