Contents
What’s it: Days payable outstanding (DPO) is a financial ratio showing how many days on average it takes a company to pay its suppliers. We calculate it by dividing the number of days in a year by the accounts payable turnover ratio.
Accounts payable arise when a company purchases inputs from its suppliers on credit. Prior to paying them when financial statements are prepared, companies report them as accounts payable, which appears in the liabilities section.
A higher DPO means the company takes longer to pay its suppliers. Although in general, it is preferred because the company has extra cash to use for other purposes such as short-term investments. But, we also have to read it in context and explore the reasons. That’s because high DPO does not necessarily have positive implications.
In addition, reading DPO according to the context in which the company operates will also provide a more objective picture. Understandably, the numbers can vary between industries.
Why are days payable outstanding important?
Payments to suppliers affect the company’s financial liquidity. Paying faster means more money coming out. If that is not offset by an adequate cash position or cash inflow, it could lead to cash flow problems.
Stock analysts or investors closely monitor this ratio to assess a company’s liquidity, along with other financial metrics.
Meanwhile, management uses this ratio to make important decisions such as working capital and whether to change suppliers or not.
Then, we also use DPO to calculate the cash conversion cycle. It’s a metric to measure how long it takes a company to generate cash, calculated by considering the average number of days it takes to sell its inventory, collect accounts receivable and pay bills.
How to calculate days payable outstanding?
The mathematical formula for days payable outstanding equals the number of days in a year divided by accounts payable turnover. The number of days commonly used is 365 days. But, some may use 360 days.
- Days payable outstanding = 365 / Accounts payable turnover
Meanwhile, we calculate accounts payable turnover by dividing the total purchases for the year by the average accounts payable.
- Accounts payable turnover = Purchases / Average accounts payable
The average accounts payable equals the current year’s accounts payables plus the previous year’s accounts payables, divided by 2. We can find the figure on the balance sheet in the current liabilities section.
Meanwhile, we calculate purchases by subtracting ending inventory from beginning inventory and adding up the result with the cost of goods sold (COGS). Here is the formula:
- Purchases = Ending inventory – Beginning inventory + Cost of goods sold
We find the inventory figure on the balance sheet, in the current assets section. Meanwhile, the cost of goods sold is on the income statement, under the revenue account.
Back to the first equation. We can rewrite it to be as follows:
- Days payable outstanding = 365 * Average accounts payables / Purchases
How to read days payable outstanding?
Look back at the first formula. Days payable outstanding (DPO) is inversely related to trade payable turnover.
While accounts payable turnover tells us how many times, on average, in a year a company pays its suppliers, the DPO shows how many days it takes the company to pay its suppliers.
The higher the accounts payable turnover, the shorter the average it takes a company to pay its suppliers, and the lower the DPO. For example, a DPO of 60 means that, on average, the company pays its suppliers within 60 days.
What does low or high DPO mean?
In general, a higher DPO is preferred because the company can retain cash longer before paying to suppliers. As a result, it needs relatively more days to pay its suppliers. And, if it has sufficient cash, it should not indicate financial problems.
Because companies can hold available funds for a longer period, they can use these funds for better purposes, maximizing profits, for example, by placing them in liquid financial instruments to earn returns. Companies can also use it as their working capital and free cash flow.
Why is the DPO ratio high?
The high DPO may be due to lenient supplier credit terms. So, companies take advantage of them and pay them in the end.
However, a high DPO can also occur because the company lacks funds. The company’s ability to pay decreases because it does not have sufficient cash. As a result, the company can’t pay its bills on time. For this reason, we must examine the company’s cash and cash equivalents position. Marketable securities should also be checked.
In addition, if the company takes too long to pay suppliers, it can worsen relations with suppliers. For example, they may refuse to offer credit. Or, they could set more stringent requirements considering the poor payability of the company.
Meanwhile, a low DPO means the company pays suppliers too quickly. As a result, cash flows out faster, and therefore, there is no opportunity to use it for other purposes before it is handed over to suppliers.
Low DPOs can occur due to the supplier’s strict credit terms. So, the company has to pay sooner. If it has alternative suppliers on more lenient terms, switching to them is reasonable.
However, low DPO can also occur because the company is trying to take discounts offered by suppliers. In maintaining good long-term relationships with customers, suppliers often offer discounts or other incentives for early payment. Thus, management may think it is better to pay early than pay late.
