While cash flow often takes the spotlight in the finance world, it's crucial not to overlook some other valuable financial metrics. Days Payable Outstanding (DPO) stands out as one such important barometer. It offers insights into various aspects of a company's financial health and financial management.
A comprehensive knowledge of DPO can empower you to leverage your supplier relationships, better manage cash flow, and optimise your processes. This guide will navigate through the following key sections:
What is Days Payable Outstanding (DPO)?
Should DPO be high or low? ‘Good’ and ‘bad’ figures
Different benchmarks in different industries
How technology can help to improve your DPO
Streamlining with Advanced Financials
What is Days Payable Outstanding (DPO)?
DPO is like a company's 'payment speedometer’, telling you how quickly or slowly they clear their bills. Company's often run on a credit system, wherein they purchase goods and services from suppliers and vendors on credit. This money owed by the company is recorded as accounts payable (AP). The average time in days the company takes to settle their accounts payable is referred to as DPO.
A DPO value of 30 would imply that, on average, 30 days are required by the company to pay back its creditors.
· DPO is a measure of time taken by the company to pay off its creditors.
· DPO has impact on company's ability to negotiate favourable credit terms with suppliers. A company with a strong DPO may have better negotiating power, leading to extended payment periods or discounts.
· Companies can strategically adjust DPO to optimise working capital.
· DPO can affect financial ratios such as the current ratio and quick ratio. A higher DPO may lead to a higher current ratio, reflecting a potentially healthier liquidity position.
How to calculate DPO
Accounts payable do not fully represent the money involved in the manufacturing of goods and services. There are additional costs, such as payments for utilities like electricity and employee wages. These costs are included in the cost of goods sold (COGS), which represents the direct costs of acquiring or producing the goods sold by a company during a specific period. Both accounts payable and cost of goods sold are cash outflows, crucial in the calculation of DPO.
Formulas for calculating Days Payable Outstanding
Formula 1
DPO = (Average AP / COGS) x Number of Days in Accounting Period
Or
Formula 2
DPO = Average AP / (Cost of Sales / Number of Days in Accounting Period)
Where: Cost of Sales = Beginning Inventory + Purchases – Ending Inventory
Days Payable Outstanding is typically calculated annually or quarterly. In case of annual calculation, the number of days in the Accounting Period is usually taken as 365. Similarly, 90 is considered for quarterly calculations.
The numerator represents outstanding payments, and these formulas consider the average daily cost incurred by the company in manufacturing products.
Instead of using the Average AP, as mentioned in the formulas above, the exact accounts payable amount reported at the end of the accounting period can be used. For instance, if you calculate DPO on December 31, you’d use the total amount owed to suppliers on that exact day. This method of calculation provides a current value of DPO rather than an average during a certain period. The choice of calculation method depends on the accounting practices of your company.
Example of calculating DPO
Consider a mid-sized retail company with steady growth. The following tables showcase their financial statements. The figures on the consolidated statement of operations represent the amount of expenses related to the cost of sales. And you can see the accounts payable on the balance sheet.
|
Consolidated Statement of Operations (in Millions) |
||
|
Line Item |
2022 |
2023 |
|
Revenue |
£520.3 |
£583.2 |
|
Cost of Goods Sold (COGS) |
£371.5 |
£419.3 |
|
Gross Profit |
£148.8 |
£163.9 |
|
Operating Expenses |
£120.4 |
£129.7 |
|
Operating Income |
£28.4 |
£34.2 |
|
Other Income/Expenses (Net) |
£3.2 |
£2.1 |
|
Profit Before Tax |
£31.6 |
£36.3 |
|
Taxes |
£7.9 |
£9.1 |
|
Net Income |
£23.7 |
£27.2 |
|
Consolidated Balance Sheet (in Millions) |
||
|
Line Item |
31-Dec-22 |
31-Dec-23 |
|
Current Liabilities |
||
|
Accounts Payable |
£58.3 |
£65.2 |
|
Accrued Expenses |
£21.7 |
£24.3 |
|
Other Current Liabilities |
£14.8 |
£16.9 |
|
Total |
£94.8 |
£106.4 |
|
Non-Current Liabilities |
||
|
Long-Term Debt |
£62.4 |
£58.7 |
|
Other Non-Current Liabilities |
£18.2 |
£20.1 |
|
Total Non-Current Liabilities |
£80.6 |
£78.8 |
|
Total |
£175.4 |
£185.2 |
This information is enough to calculate DPO. We can consider the starting balance of a period as the concluding balance of the preceding period for accounts payable.
Accounts Payable as of December 31, 2022 = £58.3 million
Accounts Payable as of December 31, 2023 = £65.2 million
Hence,
Average Accounts Payable = (£58.3 + £65.2) / 2
Average Accounts Payable = £61.75
The average balance of accounts payable for 2023 is £61.75 (in millions).
The COGS value for 2023 is reported as £419.3 million. We can take 365 as the accounting period, therefore, the DPO can be calculated as:
DPO = (Average Accounts Payable / COGS) × Number of Days
DPO = (£61.75 / £419.3) × 365 days
DPO = 53.70 days
Thus, the Days Payable Outstanding is roughly 53.7 days, indicating that, on average, the company required 53.7 days to settle its accounts payable in the year 2023. It's important to acknowledge that this is a simplified calculation, and a comprehensive financial analysis may require more detailed considerations.
Should DPO be high or low? ‘Good’ and ‘bad’ figures
The timeframe within which accounts payable are settled is arguably as important as the repayment itself, making DPO a crucial metric for giving businesses insights. It reveals nuggets of information about a company’s relationship with suppliers, as well as their efficiency with tracking cash flows and spend management. However, there's no one-size-fits-all answer to the question 'Should DPO be high or low?'. The evaluation should be nuanced, considering the specific context.
For instance, a company might allow a 60-day period for customers to settle invoices but only have a 15-day window to pay suppliers and vendors. This disparity in inflow and outflow duration poses a risk of frequent cash crunches. Hence, DPO is all about finding the right balance according to the needs and best interests of your company.
Reasons for a high DPO
A high DPO is generally regarded as favourable, providing the business with an extended timeframe to settle its dues, and leaving it with ample cash on hand. This surplus cash contributes to the company’s working capital and can be channelled into short-term investments for potential financial gains. Moreover, it allows the company additional time to convert inventory into sales revenue before addressing its payables.
Having a DPO higher than the industry average implies more favourable credit terms compared to competitors. This suggests strong relationships with creditors and suppliers, providing the company with a competitive edge in the market.
Reasons for low DPO
Equally, a high DPO may signal that a company takes too long to settle its debts, indicating potential financial struggles. This approach also carries the risk of straining relationships with suppliers and creditors who might prefer prompt payments. Such strained relationships could jeopardise future credit opportunities, negotiation advantages, and even the chance to avail discounts for timely payments.
Conversely, a low DPO indicates the company is in sound financial health, efficiently managing cash flow and promptly settling bills with suppliers. This fosters more positive relationships.
However, there's a downside to a low DPO too, as it may suggest the organisation is not utilising its capital resourcefully. For instance, if a company typically pays invoices after 10 days, but suppliers allow a 30-day window, they could potentially be earning interest on funds for an additional 20 days before payment.
Also, a lower DPO may imply a lack of trust from creditors for long-term credits and a weaker relationship with them. Thus, a DPO lower than the industry average could indicate less favourable credit terms compared to competitors.
DIO and DSO vs DPO
It is rare for a business to sell its goods instantly; hence, these goods are often stored as inventory. The time this inventory sits with the company before being sold is called Days Inventory Outstanding (DIO). When this inventory is sold, the business often won’t receive payments immediately; instead, it is given on credit to customers. The days taken in receiving these payments after goods are sold are referred to as Days Sales Outstanding (DSO). Similarly, as we’ve discussed, the time taken by the organisation to deal with its own payables is called Days Payable Outstanding (DPO).
DIO, DSO, and DPO indicate how well they are managing inventory, receivables, and payables, respectively. These metrics are necessary to determine the Cash Conversion Cycle (CCC). Achieving a lower CCC, facilitated by low DIO and DSO and a higher DPO, is generally preferred as it signifies an efficient cash conversion process and effective management of working capital.
Different benchmarks in different industries
The ideal value for Days Payable Outstanding varies widely across sectors, with each region, industry, and niche having its own specific averages. Additionally, these averages change with time, the size of the company, and prevailing market conditions. For instance, manufacturing industries with longer production cycles tend to have higher DPO values.
Similarly, established corporations can leverage their market dominance to secure favourable payment terms and higher DPO compared to startups. It's crucial to note that there is no universal benchmark for Days Payable Outstanding; what is considered healthy in one industry or region might be deemed unfavourable in another.
The pros and cons of using DPO
With insights around your creditworthiness, liquidity, and overall financial health, an understanding of Days Payable Outstanding certainly comes with its benefits. However, there are also some potential drawbacks, so let’s take a look at some of the main pros and cons:
|
Pros of DPO |
Cons of DPO |
|
Helpful in assessing financial health |
It alone cannot provide a comprehensive view, considering other liquidity ratios is essential for a complete assessment of financial health |
|
Easy to calculate |
There is no universal measure of what is a good and bad figure |
|
Often the first step in understanding liquidity and cash constraints |
DPO alone may not provide a reliable and consistent measure of liquidity constraints, as it is influenced by the company's size and negotiating ability, potentially leading to misinterpretations |
|
Useful for measuring the relationship with suppliers |
Not the only factor on which supplier relationship depends and hence requires further research to fully understand this element |
How technology can help to improve your DPO
Striking the right balance in Days Payable Outstanding (DPO) is paramount for optimal financial management. Leveraging technology can simplify this process. Implementing budgeting and forecasting tools allows for accurate projections, facilitating effective cash flow management. With insights into future expenses, you can optimise payment schedules and enhance your DPO.
Advancements in technology have made financial processes more efficient. Now you can track your cash flow in real time. This enables you to monitor and strategise payments to suppliers, improving DPO without compromising operational efficiency.
Positive supplier relationships are vital for expediting goods receipt. Automation tools for accounts payable and e-payments contribute to this goal by streamlining the invoice processing workflow. Improvements like digitising invoices, automating approvals, reducing manual data entry, and utilising electronic payments significantly reduce processing time and shorten DPO.
Streamlining with Advanced Financials
Advanced Financials is a financial management software designed to streamline processes and enhance your control over financial decisions. With automated reporting, it minimises manual work and provides key insights effortlessly, driving strategic initiatives across the organisation. Being cloud-based, it facilitates seamless communication of real-time data across departments, aiding in informed decision-making regarding payments and supplier relationships for DPO optimisation.
The software supports finance teams in managing various accounting elements, including general ledger, accounts payable, credit management and invoice management.
Additionally, Advanced Financials offers a self-service portal for suppliers. Here, registered suppliers can address queries, review contracts, catalogues, purchase orders, and invoices directly through the portal. This interactive platform strengthens supplier relationships, contributing to favourable DPO terms and ensuring optimal deals.
Explore more about Advanced Financials and take the next step towards optimising your financial management today.
