Definition: The average number of days’ sales that are owed to a company at any time. The calculation:

1. Compute Sales Per Day: Sales / 365
2. Compute Days’ Sales Outstanding: Ending Accounts Receivable / Sales Per Day

If in the process of doing ratio analysis Accounts Receivable Turnover is calculated, it can be used quickly compute this ratio: 365 / Accounts Receivable Turnover.

Example: Super Sales Co. achieves Sales of $1,200,000 this year. At the end of the year, its Accounts Receivable balance is $100,000. The company’s sales per day is $1,200,000 / 365, or $3,288. Therefore, the Accounts Receivable balance represents $100,000 / $3,288, or 30.4 days of sales that are owed to the company.

As we noted above, if the Accounts Receivable Turnover ratio is known, it can be divided into 365 to get this ratio. The Accounts Receivable Turnover is $1,200,000 / $100,000, or 12. Dividing 12 into 365, we also get 30.4 days.

Investeach explains: The lower this ratio, the better. A lower ratio means that companies are collecting from their customers is a shorter period of time.

Note that this ratio makes several assumptions that you should be aware of. One critical assumption is that all Sales are made “on account” (ie, none are paid with cash at the time of sale) meaning that they all pass through the Accounts Receivable account. What would happen if a company was paid in cash for some of its sales? Let’s consider the above company. If $200,000 of its sales were paid in cash, then the amount of sales going through Accounts Receivable account would be reduced to $1,000,000. This means that the “on account” sales per say  is $1,000,000 / 365, or $2,740. Dividing this into Accounts Receivable gives us Days’ Sales Outstanding of $100,000 / $2,740, or 36.5 days.

A second aspect to note is the Accounts Receivable account balance at the end of the year is just a snapshot at that time. It may or may not represent the average amount owed over the course of the year. To be more accurate, you could average the Accounts Receivable balance at several points during the year, such as the balance at the end of each month.

Riddle me this:

1. What is Days’ Sales Outstanding designed to measure?
2. What other ratio is it related to?
3. Explain why a lower ratio is better than a higher one.
4. What is a key assumption made about the company’s sales for this ratio to be accurate?