The APQC Blog

Using May’s Metric of the Month – Days Sales Outstanding - to focus on value

CFO Magazine’s May Metric of the Month column (authored by my colleague, Perry D. Wiggins) discusses Days Sales Outstanding (DSO) with an excellent analogy to scuba diving. I highly recommend that column as Perry provides many useful ideas you can immediately use to improve DSO.

Perry also briefly touched on a related concept (Days Cash on Hand) that this blog expands upon. Like DSO, days cash on hand focuses on liquidity. It often enters discussions when an organization faces a liquidity crisis such as potential bankruptcy. When it becomes the focus of conversation it usually requires dramatic action such as emergency funding often via a letter of credit, potential bankruptcy filings, or the rapid sale of choice assets. Using Perry’s scuba diving analogy, you use it when you need to prove you have enough air left to reach a significant point of greater safety. As such I recommend avoiding discussing it as it can to spook bankers. To avoid liquidity issues, consider the following four ways to improve your position.

First, consider more ways to capture cash directly from sales. If your goods and services are small dollar items, consider accepting and promoting the use of credit cards as an easy way for customers to pay for your services. As a vendor you will certainly pay a cost to accept them but you funding is typically next day and you can reduce your collections activities. You can also emphasize that it saves administrative costs for your customers as the clerical costs are also reduced (processing an electronic credit card statement is far easier than dealing with individual invoices). If you transactions are much larger you can still use credit cards but you need to negotiate lower costs with your card processors who will typically do so if your average transactions are substantially larger.  

A second approach looks at inventory similar to how you look at receivables. It focuses on days sales in inventory. This it typically applied to finished goods inventory (think of the number of vehicles a car dealership has ready for sale). These represent assets ready to convert back intro cash. Is your on-hand inventory value is above the norm? Then action is needed. Businesses should focus on quicker ways to sell.

If you extend this type of thinking you quickly think of increasing your velocity or throughput. If you spent your entire career in finance this may be new to you. If you look at operations you will find many different approaches to tackle this idea. I recommend you examine the late Eliyahu M. Goldratt’s work, particularly his Theory of Constraints.

Many years ago, I was in the process of converting my career from financial auditing into full time management consulting. As part of that transition I read a business novel - The Goal: A Process of On-Going Improvement by Eliyahu M. Goldratt and Jeff Cox along with the companion book The Race by Goldratt and Robert E. Fox. Both books show how to think very differently about what is possible. The Race went so far as to suggest that credit sales could be a source of working capital rather than just a use (You achieve this when you take what you buy, convert it into goods or services, sell those goods and services,  and collect the related receivables before you initial payables become due). Achieving that speed was certainly what Goldratt sought.

In addition to gaining an appreciation for speed, I came to understand that the multiple streams of value are created in each business interaction. In addition to evaluation value in aggregate, you can also segregate and evaluate the value streams on a stand-alone basis. Whenever a transaction also provides extended terms of payment, the parties have inserted a banking function as part of the value stream. If the invoice terms call for payment “2/10, net 60 days” it is offering a 2% prompt pay discount or an alternative to receive the full balance in 60 days. This effective provides a short term no interest loan (I say “no interest” but the reality is that the interest costs in hidden within the purchase price).

A fourth approach has evolved where third-party companies have established electronic marketplaces to allow you to put portions of your payable up for discount auction promising to pay them in 5 or 10 days in exchange for additional discounts. The vendors who you owe are asked to provide additional discounts for essentially immediate payment. If you like the offers you can increase to volume of cash available for early payment. If you do not like the offers you can simple decline. Either way, technology is making the banking element of transactions easier to find and to facilitate.

The best way to use these concepts (as well as those suggested by Perry) is to do so proactively. If you apply them now, you are more likely to avoid needing them in a crisis.