Why You Should Switch to the Countback Method to Calculate DSO

One of the projects assigned to Pete Knox, now head of credit for Nestle's U.S. while he was on a two-year assignment at their Swiss headquarters was to come up with the best method to calculate Days Sales Outstanding (DSO) and then to implement that method consistently around the world.

After considerable study, he chose something called the "Countback Method," which originated in their Malaysian market. The Countback Method makes the most sense, he felt, because it takes sales fluctuations into account, while most DSO calculations assume that sales are equal from period to period, something not true at most businesses. Read on for the reasons you'll probably want to change to this method once you understand it's simplicity and value.

DSO: Here to Stay
Some people argue that we should get rid of DSO because the calculations are biased by the sales trend and therefore are not a suitable measure of receivable performance. Although they are absolutely correct about this deficiency, like it or not, DSO is here to stay, if only because it's the only thing that CFOs and investors know. That said, there remains the issue of which DSO formula you should use. The most commonly accepted formula is based on a three-month sales average. (See the chart below for this and all formulas referred to in this article.) This eliminates some of the vagaries of monthly sales volume and allows quarter-to-quarter comparisons.

However, an exchange on the Credit Today ListServ revealed increasing use of the Countback Method for calculating DSO. Here's how it works, as explained by Kent Knopp-Schwyn, now assistant credit manager with COKeM International Ltd. (Shakopee, MN). "You start with your month-end net A/R balance (A/R less bad debt reserve). From that, remove the reported revenue for the current month (that will be 28, 30 or 31 days of your DSO right there). Figure out what the balance remaining is.

"Take that balance as a percentage of last month's reported revenue and multiply that times the number of days in the previous month. That gives you the days to add to the number of days in the current month." If your DSO is over 60 days you may have to count back three months. Keep in mind that the simplicity of the method is such that you can substitute any time frame for the period in question. If you have shorter terms, such as net 10, you might want to use a weekly, rather than a monthly time frame, as noted above.

Providing Another Perspective on A/R and Sales
The Countback Method is a substantially different formula than the standard DSO calculation, and it is more strongly influenced by the current month's activities. Says Tom Close, formerly senior manager, credit and accounts receivable at The First Years Inc., "the Countback Method does not use a three month average A/R balance to calculate DSO. It uses the current month's ending A/R balance for the month you are measuring and analyzing. The Countback Method, therefore, does not carry over the same past due and sales influences for three months running. Thus, you are providing a more accurate picture of DSO and its month-to-month variations caused by monthly fluctuations in sales and past due receivables."

He also notes that "the Countback Method gives more weight to the current month's sales figure than prior months' sales, because it correctly assumes that most of your A/R balance consists of current month's sales, not the prior months. Unless your sales are the same each month, this can make a big difference in your month-to-month DSO figure. It also takes into account the real effect of 28-day verses 31-day sales months in your current month's A/R balance."

Addressing the Unique Characteristics of Your Business
Because of these attributes, and depending on the characteristics of your business or industry, there are additional advantages of using the Countback Method. For example, in a seasonal business, fluctuating sales are the norm, and how you react to them is critical.

As such, year-to-year comparisons can be more important than rolling month-to-month comparisons. "I use the Countback Method because we are a seasonal business. I believe it more accurately reflects a proper DSO," states the head of credit & financial accounting at a consumer and military products manufacturer.

And of course, your terms have an effect on DSO. "In my industry, there are no terms other than COD that are less than 30 days," explains Cheryl Fischer FCI, formerly with Royal Pipe Systems, and now with Krug, Inc. "We have discounts, but they do not fall before the first 30 days--that's just the industry standard. I like this method because it more accurately reflects that, in our situation, the current month's sales will not be collected within the first 30 days."

Often, there are changes between relative factors that determine DSO. "I have used the Countback Method in my last two jobs. If your sales are up and down, this formula results in large swings in your DSO, but to me it seems a lot more reflective of reality," noted the director of credit and collections at Alco Industries. "I temper the swings by providing average terms of sale for the month to help put the results in perspective," he adds.

Keep It in Context
A proper perspective is the key for understanding what any DSO calculation reflects. Viewed without any other reference points or context, DSO can be ambiguous, if not downright misleading. You can avoid that by never letting a single DSO calculation stand by itself.

That is why many companies will look at DSO in more than one way. Thomas C. Walsh, formerly vp customer relationship management at Harman International and now Executive Director, Financial Operations at Henry Schein, says that "the Countback Method is the most accurate; however, quarterly is generally used for benchmarking purposes.

"Consequently, we use quarterly, 12-month rolling (similar to quarterly, however, incorporating 12 months) and the actual Countback Method." Looking at these three measures in tandem allows Walsh to better gauge the actual DSO trend despite the fluctuations and limitations of each measure when taken individually.

Another good way to look at any DSO formula is to graph it against sales volume and A/R balances. You might even break the receivables out into both current and past due segments. That way, you can readily see the factors driving the ups and downs in your DSO calculation.

Quick Takes on the Countback Method

• DSO as the primary measure of A/R is here to stay, as it's all that CFOs and investor analysts know.
• The standard formula for DSO is the 3-month weighted average. Its advantage includes a smoothing of the ups & downs due to sales fluctuations. But the problem is that, while it gives an average for the prior quarter, on a monthly basis, it can be skewed.
• We believe a more intuitive formula to calculate DSO is the "Countback method."
• The Countback Method is advantageous because it more accurately reflects the actual time to pay in a given month.
• Never use any DSO calculation by itself. Perhaps include the current month's DSO along with a quarterly figure, and a 12-month rolling average, and compare to the year-ago figure. In addition, you should show comparisons to sales, total A/R, and past dues balances.
• You can use the Countback Method to calculate Best Possible DSO (BPDSO) and Average Days Delinquent (ADD), two other important measures of your performance.

Calculating Your Average Days Delinquent
Close uses a variation of the Countback method to calculate Best Possible DSO. He simply substitutes "current" A/R balance in place of "total" A/R balance. Best Possible DSO (BPDSO) assumes all invoices are paid on their due date. The difference between your DSO and BPDSO is your Average Days Delinquent (ADD). By breaking DSO into these two sub-components, you can monitor the effect of both terms and past due balances on your receivables. If you are using the Countback Method to calculate your DSO, for consistency's sake, you will want to also use it as the basis for your calculation of BPDSO and ADD. Because every company is different, you need to adopt metrics that reflect the nuances of your business. The metrics you chose should always help you paint the clearest possible picture of your business's receivables.

Countback Method for Calculating DSO

1. "Countback" your DSO in whole month* increments:
   Total receivables - current Month's sales = Prior Periods' Receivables.

   If the remaining number above is greater than the prior month's sales, repeat the process. That would mean your DSO is going to be greater than 2 months. This is your "days counted back."

2. Add DSO from periods prior to the whole month increments in step 1 above:
   Using the period prior to how far you "counted back," calculate the remaining portion of your DSO.

   Total Preceding Periods Receivables X Days in Previous Months = "Added Days" Preceding Period's Sales

3. Add steps 1 and 2 together:

   Days Counted Back (from step 1) + Added Days (from step 2) = DSO

* Note: You can substitute any period you want in here. For example, you can use a weekly increment.

Countback Method for Calculating Best Possible DSO (BPDSO)
To calculate Best Possible DSO (BPDSO) using the Countback method, substitute "current receivables" in place of "total receivables" from the formula above. And simply calculate it the same way.

Countback Method for Calculating Average Days Delinquent (ADD)
To calculate Average Days Delinquent (ADD) using the Countback method, substitute "past due receivables" in place of "total receivables" in the main Countback formula above.

Or, BPDSO - DSO = ADD