How to Analyze Trade Credit - Pt. 3

The DSO, in its simplest formulation, on an annual basis and without considering the effect of VAT, is calculated as follows:

For example, if on 12/31 the credits are equal to 10,000, compared to annual revenues of 120,000, the DSO will be equal to:

This is also easily interpretable because, considering a constant turnover (in the example 10,000 euros/month) and constant collection conditions equal to 60 days, at the end of the year the receivables towards customers will contain both the receivables arising from the December sales and those arising from the November sales, for a total therefore of 10,000 + 10,000 = 20,000.

To obtain a slightly more realistic formula, it is necessary to consider, in addition to the actual length of the year (365 or 366 days), also the effect of VAT , which, where present, is incorporated into the credits.

In order to relate credits to revenues, in fact, the 2 quantities must be made homogeneous, separating VAT from credits.

In this case, going back to the previous example, considering that the revenues are all invoiced with VAT at 22%, we will have credits of 24,400 at the end of the year. The calculation of the collection time therefore becomes:

The result is similar to the previous one, but this time we have considered credits including VAT. The result obviously does not come to exactly 60 days as in the previous example (in which we had considered the school case with months of 30 days and multiplier 360), but the informative value of the result does not change!

In the presence of sales subject to seasonality, or in intra-annual situations, it may be appropriate to calculate the DSO also with other time horizons.

So for example you will have a 30-day DSO, calculated as follows (note: for simplicity let's go back to the formulas without VAT and with 30-day months):

Or, in the case of 60-day DSO:

Or again, in the case of 90-day DSO:

Let's try to apply these different calculation methods to a concrete example, and see how these indicators behave, thus declined according to the three time horizons of 30, 60 and 90 days.

Example #1

Consider a company with sales distributed over the months as in the figure above, with a certain seasonality that sees sales intensify at the end of the year. The same collection conditions are applied to each sale:

• 40% at 30 days
• the remaining 60% within 60 days.

Knowing this data relating to collection times, we can say that the DSO will be equal to:

With these collection times, the credits at the end of each month, as indicated in the figure below, are calculated as follows (e.g. the month of June):

However, if we put ourselves in the shoes of an external analyst and, looking only at the balance sheet data, we calculate the DSO with the classic method on an annual basis, we would obtain a misleading figure, dictated by the seasonality of revenues:

Therefore, if we wanted to calculate the DSO with the 3 temporal declinations mentioned above, we would obtain a distribution of results that is more true, albeit with a certain variability within the various methods, as highlighted by the conditional formatting applied to the Excel sheet in the previous figure, and by the related graph that follows:

The 30- and 90-day DSOs are those that present the greatest variability, going from a minimum of 45.2 to a maximum of 52.8 for the former, from a minimum of 45.0 to a maximum of 52.2 for the latter.

The most realistic method, which therefore comes closest to the real duration of 48 days, is the 60-day DSO, which varies from a minimum of 46.6 to a maximum of 49.0. It is no coincidence that the formula for this indicator uses data from 2 consecutive months, which best approximates the collection time frame we have hypothesized (40% after 30 days, 60% after 60 days).

Let us now consider that a more advantageous payment extension is granted to the customer, as in the example given here.

Example #2

The sales are the same, what changes are the collection conditions: 15% at 30 days, 20% at 60 days, the remaining 65% at 90 days (consequently, the credits at the end of each month will also vary!).

Knowing this data we know that the DSO will be equal to:

The variability of the results, in addition to the usual conditional formatting, can also be deduced from the following graph:

In this case, the most realistic method, which therefore comes closest to the real duration of 75 days, is the 90-day DSO, which varies from a minimum of 74.0 to a maximum of 76.4. It is no coincidence that the formula for this indicator uses data from 3 consecutive months, which best approximates the collection time frame we have hypothesized (15% after 30 days, 20% after 60 days, 65% after 90 days).

Even in this case, the data from the 3 methods just seen are still more truthful than the DSO calculated on an annual basis, which would instead lead to the following overestimated result:

(continued in part 4 )