Days Payable Outstanding
Managing cash flow is chief to measuring a company’s performance to know how it is fairing and note the areas that need improvement. Regular tracking of key measures is vital for aligning goals and priorities. Days payable outstanding or DPO is among the most effective metrics to track to check on overall efficiency and productivity. It’s a process that offers valuable insights into your cash cycle and process efficiency. Reading this article will take you through days payable outstanding meaning, its importance, what it tells a business, sample calculations, and days payable outstanding example.
What Is Days Payable Outstanding (DPO)?
We start by tackling the query of what is days payable outstanding. DPO describes a financial ratio indicating the days a company takes to pay off its account payables within a given period. Also known as creditor days or payable days, most companies calculate the ratio quarterly or annually. If a company’s DPO is 21, it takes twenty-one days to pay trade creditors on average.
The Importance of Days Payable Outstanding
DPO is an important component of the Cash Conversion Cycle which companies use to determine how long money is tied up in working capital. The ratio indicates how well a business is managing its cash outflow. Days payable outstanding is also an excellent indicator of a company’s dependency on trade credit for financing (short-term). Furthermore, days payable outstanding can help a firm balance its outflow and inflow tenure.
For instance, a company cannot have a 90-day policy for its clients to pay for goods and services but have a 30-day period to pay its vendors and suppliers. It can easily result in a mismatch, which can often increase the company’s chances of experiencing a cash crash. Businesses must, therefore, strike a balance with DPO.
What Does Days Payable Outstanding Tell You?
Most companies acquire utilities, inventory, and other services on credit. The action results in accounts payable, a major accounting entry that enables a company to know its financial obligations to pay off short-term liabilities to suppliers or creditors. Beyond the total amount a company pays, it takes to pay these bills is crucial for any business. DPO attempts to measure the average time for outward payments.
What Is the Difference Between Dpo and Dso?
DPO and DSO are vital financial metrics for a firm’s cash flow. DPO measures how a business manages its accounts payable by measuring the average days it takes to pay its bills and invoices to credit traders like financiers, vendors, or suppliers. DSO, on the other hand, stands for Days Sales Outstanding. A working capital ratio measures a company’s time to collect accounts receivables.
The working capital ratio differs from days payable outstanding. DSO shows how well a company manages its accounts payable by measuring the average days to collect debts. DSO is another crucial component of the cash conversion cycle in that it measures the window it takes to convert its inventory investment into cash. Companies should aim to have low DSO because it indicates that they are doing a great job collecting outstanding payments.
Sample DPO Calculation
To calculate DPO, you use the following days payable outstanding formula:
DPO = Accounts payable X Number of Days / Cost of Sales
The terms to note when using the above formula include:
- Accounts payable is the short-term liabilities that a company accrues and needs to pay back to continue business operations.
- The number of days defines the period that the firm uses to calculate DPO. It can be annually, monthly, or weekly depending on the business and its policies.
- Cost of sales is the total manufacturing expenses a company incurs to get its goods or services to its target market. It can include transportation, raw materials, rent, and other resources that form labor, inventory, and additional utility costs.
Check out examples of DPO below:
- Organization Y has an outstanding payable of $500. The cost of sales of producing its products is $900, and the business wants to calculate DPO for 30 days. They will calculate this by
500 x 30 / 900 = 16.6
The DPO of organization Y stands at 17 days on average.
- Take a look at statistics from company B as other days payable example:
- The firm’s accounts payable for the quarter are $ 150,000
- $300,000 is the value of inventories at the beginning of the quarter
- $1, 5000 0000 accounts for total purchases made during the quarter
- Cash purchases during the quarter are $750, 000
- Inventories valued at $150,000 are the inventories the company has not yet sold at the end of the quarter.
Here is how to calculate days payable outstanding:
- First calculate cost of goods sold: $300, 000 + 1, 500, 000- 150,000 = 1, 650,000
- Proceed to calculate DPO by: 150,000 X 90 / 1, 650, 000 = 8.18
The DPO for company B is around 8 days.
High DPO or Low DPO?
A company with a high DPO takes a longer period to make payments to trade creditors. Low days payable outstanding indicates that a firm does not take too much time to make payments. Generally, companies with high DPOs are considered more favorable.
In most cases, having a high DPO implies that a company is keeping funds for longer; hence, it is slow to pay back liabilities. It can also mean that a company is more flexible in utilizing cash available for investment or working capital purposes.
When calculating days payable outstanding, companies should be cautious not to record extremely high DPOs. The high figures normally indicate liquidity issues. Conversely, a low DPO may suggest that a business needs to negotiate credit terms from their trade creditors.
Some businesses can benefit from low DPO in that there are suppliers that offer discounts for early payments. Financial experts agree that DPO value should not generally exceed the 40-50 days limit. This is an ideal limit for many businesses to manage a healthy cash flow.
However, keep in mind that days payable outstanding normally depends on a business’s industry. For some companies, a high DPO could end up jeopardizing business relationships with suppliers and vendors. Suppliers may refuse to supply required materials if a company takes too long to pay for their services.
Multiple businesses use days payable outstanding extensively for business operations. It is helpful in the trading cycle and the general trend in the market. A company can effectively use DPO to gauge whether its payment policy is conservative or aggressive. You can use the formula above to know your business’s DPO to discover if the entity is on the right track.