For DSO calculation formula, should you use gross or net AR?

Ronald Snyder's Profile

DSO Calculation FormulaIts not uncommon in healthcare that you bill at a submitted charge but receive an allowed amount then contractually adjust the difference. Therefore the AR is gross but only can be netted down at payment. We use the gross AR to determine DSO should we be using Net (again because its open AR don't have the net yet) or both? Thanks Ron>

 

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State your AR in the DSO calc on the same basis on which you're stating your credit sales (probably gross). A DSO calc which uses gross credit sales but net AR would return a false reading in the favorable direction.

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You will have less headaches if you use the numbers on your financial statements for this calculation. If you are calculating DSO at the end of a quarter, divide revenue on your P&L by 90 and divide that number into AR as presented on your balance sheet. This way, you will be calculating the same way a third party would do if they were reviewing your numbers.

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I agree with Lyle. 3rd parties use financial statement numbers and the relevant DSO financial statement numbers (sales and A/R) are NET numbers. From one who has been there and done that, be assured, if you internally calculate DSO differently than a 3rd party, the 3rd party will hoot and howl loud and wide that your calculation is incorrect, regardless of his calculation's accuracy.

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Just chiming in to agree, and I particularly appreciate Terry's comments about the importance of using business practices that mirror how third parties view things.

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Ronald,

Great question!

Depending on what the calculation is being used for I think you need to be careful as to the interpretation.

If you are calculating DSO as a component of communication (or as a "back pocket" support item in that communication) to 3rd parties using the methodology they would also be able to perform is certainly appropriate, as everybody has suggested.

If you are calculating DSO as an element of the Cash Conversion Cycle, and you are using the resulting number as an input into a decision process - cash planning purposes, liquidity buffer requirement, etc. - you may want to be a little careful.

I wanted to verify the gross / net calc, and did so as follows:

Ending (or Average) AR=1000, Annual Sales=12000, DSO = 1000/12000*360 = 30

Assuming the contractually adjusted rate is 60% of the gross, on a net basis:

Ending (or Average) AR=600, Annual Sales = 7200, DSO = 600/7200*360 = 30

But.....

In some business situations getting to that net amount takes time - negotiations need to occur, disputes require resolution, sign-offs have to happen, etc. For that reason, some items can "linger" in AR longer than others, especially if they are for large amounts.

So, if the ultimate contractually adjusted rate sitting in AR is 60% (as in the example above), but overall sales represent a rate of 80%, the Gross Method is no longer the same as the Net Method, which now would be:

Ending (or Average) AR=600, Annual Sales = 9600, DSO = 600/9600*360 = 22.5

I think this would be the rate at which you are actually collecting the cash.

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Thanks for pointing out the equality (subject to the condition you described) of the Gross-Gross or Net-Net calculation. That was the point I was getting at implicitly, that mixing Gross apples and Net oranges would make the calculation an exercise in GIGO.

Ronald stated that he's running his DSO calcs prior to having net AR figures available.

But IF (with a nod to your post's caveat) he can know the actual discount rate in advance within a narrow band and with reasonable certainty, he could run his DSO on a gross-gross basis and the result will be the same as any subsequent DSO calcs using net-net from the financials.

Certainly if he's cranking out DSOs for external consumption (rather than internal mgmt) AND the final discounting rates are unpredictable, he'd base the calcs on whatever net numbers the external party would be looking at.

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Choose the balances that will achieve the purpose of the intended analysis.

If you are analyzing cash flow, use the A/R balance that you intend to collect.

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This brings up another conundrum for me. I may have been calculating DSO wrong, but to me it doesn't make sense to compare the revenue (i.e. before sales tax) to the A/R balance which does. Also, when considering revenue for the period, do you back out cash sales?

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@Call Joe, both of the issues you raise (including sales tax in numerator but not denominator; including cash sales in revenue) would derail the accuracy of the calculation. The purist would adjust for both.

As a practical matter you'd probably evaluate the time and effort required to purge the taints from your calc numbers against the incremental accuracy obtained thereby, and make a cost-vs-benefit call.

Some companies disregard the cash sales error factor when cash sales make up a negligible portion of total revenues, for example.

On the other hand, given the simplicity of the DSO inputs and the current state of technology, the "but it's too hard to adjust for that..." argument is running out of gas.

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