You can learn a great deal about your company’s payment practices by understanding how long it takes to pay vendors, suppliers, and other creditors. In the modern world, it’s thus essential to be familiar with metrics like days payable outstanding (DPO) and accounts payable turnover ratio.
In this article, we’ll take a closer look at DPO and how it can help you keep track of your company’s financial statements.
What is Days Payable Outstanding (DPO)?
Days Payable Outstanding (DPO) is a working capital ratio that measures the average number of days it takes a company to pay its invoices and bills to its creditors–including vendors, third party suppliers or creditors.
The ratio, which is calculated on a quarterly or annual basis, can help you determine how successful your company manages its accounts payable (AP) and whether you need to make any adjustments to your cash flow management strategy.
Understanding Days Payable Outstanding
In most cases, a company uses credit to purchase products, utilities, and other essential services. Accounts payable is the fundamental accounting entry that shows a company’s commitment to pay its creditors or suppliers for short-term obligations.
Apart from the exact amount to be paid, it’s also necessary to think about the timing of the payments—from the time you get the bill to the time the money actually leaves your account. Until the supplier receives payment, the cash remains in the buyer’s hands and they can use it however they want.
DPO is computed by taking standard accounting figures over a specific period of time to calculate this average time cycle for outward payments.
Days Payable Outstanding Formula
Keeping track of your company’s progress on a regular basis is crucial to its success. DPO is one of the most valuable metrics for evaluating overall efficiency and productivity in accounts payable. This method doesn’t take time or effort, but it will make your processes and cash cycle more efficient.
It’s essential to understand and optimize all of your AP operations by taking the time to calculate DPO.
DPO is calculated as follows:
Days Payable Outstanding = (Average Accounts Payable ÷ Cost of Goods Sold) × Average Number of Days in Accounting Period
Days Payable Outstanding = Average Accounts Payable ÷ (Cost of Goods Sold ÷ Number of Days in Accounting Period)
Cost of Goods Sold = Beginning Inventory + Purchases − Ending Inventory
A company needs raw materials, utilities, and other resources to make a product that can be sold. Accounts payable is the amount of money owed to a company’s suppliers for purchases made on credit under terms of accounting practices. The financial statement shows all transactions under AP, which are considered liabilities.
Cost of Goods Sold
Cost of Goods Sold (COGS) is the total amount of money spent by the company to make the product or get it to the point where it’s ready to be sold to a client. It’s comprised of all manufacturing-related direct costs, such as raw materials, utilities, transportation charges, and rent. This can be noted on a company’s income statement. Your total credit purchases approximate COGS, so the two are relatively interchangeable.
Number of Days
The number of days in the appropriate period is often calculated as 365 for a year and 90 for a quarter.
Example of Days Payable Outstanding
Katherine owns a bakery that sources produce and staples from several local vendors. At the end of the year, she had $500,000 in accounts payable on the balance sheet. Each day, she paid an average of $7,260 ($2,650,000 ÷ 365 days) in invoices. Katherine used the two previous formulas to calculate her DPO.
We can construct the following equation using Formula A:
Days Payable Outstanding (DPO)
69 = ($500,000 ÷ $2,650,000) × 365 days
On average, Katherine pays her invoices 69 days after receiving them.
Alternatively, if we look at our work with Formula B, we can observe the following:
Days Payable Outstanding (DPO)
69 = $500,000 ÷ ($2,650,000 / 365 days)
Using formula B, the DPO is also 69 days.
What’s Considered a Good Days Payable Outstanding?
From the perspective of working capital management,a high DPO is advantageous since companies that take a long time to pay their suppliers can utilize their cash for a longer duration. It could, however, be an indication that a company is having trouble meeting its commitments on time.
An industry-wide benchmarking approach can be useful in determining your company’s quality of DPO. A DPO that is higher or lower than the standard could be an indication of a number of different factors.
A high days payable outstanding (DPO) is generally considered a good thing. It means that the company is taking a long time to pay its suppliers, allowing it to use its cash for an extended period.
There are several reasons why having a high DPO might be advantageous. First, it could indicate that the company is in a solid financial position and can meet its commitments on time. Second, it could mean that the company is not reliant on short-term debt to finance its operations.
Finally, a high DPO could indicate that the company is doing an excellent job managing its working capital.
Low DPO could indicate that a company is small, doing well financially, or otherwise has an abundance of cash flow.
Some other low DPO signals include the company not being as efficient in its collections process, or perhaps that it cannot negotiate favorable payment terms with its suppliers.
Having a low DPO, however, is not necessarily a problem. It could also imply that a company delivers its payments to its suppliers on time to capitalize on early payment discounts, thereby ensuring a high return on its excess cash.
When comparing DPO practices among businesses, consider that different industries and locations can have varied DPO practices. Because no exact number defines a “good” or “bad” DPO, it is only advantageous to compare it to other companies in the same industry.
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What Data Does DPO Show You?
Companies with a high DPO might use the cash they have on hand for short-term investments and improve their working capital and free cash flow. However, having a higher DPO value isn’t necessarily a good thing for the company.
By delaying payment of its creditors, the firm risks compromising its relationships with suppliers and creditors, who may refuse to provide trade credit in the future or give it on conditions that are less beneficial to the company.
In addition, the company may be missing out on any discounts available for timely payments, and it may be paying more than is necessary.
Importance of Days Payable Outstanding
Keeping an eye on DPO ensures that the company is achieving the right balance between cash flow and vendor satisfaction.
Understanding DPO is critical, even if it is only a minor component of your overall financial and accounting strategy. It will assist your firm to expand, maintain a healthy financial statement, and compete effectively in today’s market.
Want to Improve Your Days Payable Outstanding?
A company must optimize its accounts payable in order to improve the days payable outstanding ratio. You can free up working capital to boost your company’s growth, improve corporate cost management, and simplify accounts payable operations by taking a strategic approach.
In order to increase DPO, reworking your invoicing payment process can be beneficial. Additionally, it’s a good idea to establish preferred supplier lists so that you can negotiate the best payment terms for your business.