As reiterated (ad nauseam), CASH IS KING! To convert revenue into cash, one of the major areas a company must execute is to collect debts from its’ customers. This is represented by the DSO ratio, which is a key performance indicator (KPI) of the company’s credit control function. The DSO ratio is made up of two components, namely Trade Receivables and Revenue. Just to recap:
Trade Receivables consist of amounts due from customers. These amounts arise because most business gives credit period and limits to their customers. The average credit period given to customers vary depending on the industry they are in.
Revenue represents sales to customers for goods sold or services rendered.
Significance of the DSO ratio
The DSO ratio is important is it indicates the amount of time the company requires to collect the debts from the customers. A very long DSO ratio (e.g. in excess of 90 days) would indicate that the company is facing credit collection problems or the recoverability of such trade receivables is in doubt. Whenever the DSO ratios balloons substantially in comparison with prior years, it is an indication that the company may have expanded too aggressively or relaxed its’ credit control procedures in an attempt to secure additional sales.
Conversely, an favorable DSO ratio (i.e. 30-60 days) usually indicates that the company is managing its’ credit control function effectively and are collecting all its’ debts promptly. Companies with low DSO ratios are usually well managed and should not face any cash flow problems. When considering whether to invest in the shares of a particular company, a low DSO ratio is a very favorable sign.
A review of Nestlé DSO ratio indicates that it has been hovering around 29 to 32 days. This is extremely favorable. On average, Nestlé takes approximately about a month to collect debts from its customers after it’s’ products are delivered and sold to its’ customers.
This is however, not surprising as the bulk of it’s’ customers are likely to consist of reputable dealers, supermarket and hypermarket chains that have strong financial standing. Further, there is a lower risk of any huge exposure of bad debts as compared to companies in other riskier industries such as construction industry.
By converting its’ trade receivables to cash in such a short time frame, Nestlé is able to generate strong operating cash flows of approximately RM319MIL per annum to sustain its’ operations.
Remember, PROFITS DOES NOT EQUAL CASH!
Always keep a lookout for the DSO ratio. If profits has increased substantially but DSO ratio has ballooned (e.g. exceeding 90 days from 30 days in prior years), all is not well in the company. Ultimately, in order for profits to be realized, the debts from customers must be collected. If debts from customers are not collectible (bad debts), then the increase in profits is meaningless!