Days payable outstanding (DPO) is a financial ratio that measures the average number of days a business takes to pay its bills or invoices to its trade creditors.
These may include suppliers, vendors, financiers and others. It refers to the time a business takes between the purchase of goods or services on credit and the payment of that credit.
DPO is a key financial metric that indicates the business’ liquidity and cash management efficiency.
DPO is generally calculated on a quarterly or annual basis.
A business with low days payable outstanding indicates that they are paying their bills or invoices quickly.
This points to effective cash management and strong liquidity.
However, businesses with a high DPO may be seen as a red flag as it indicates that they are taking longer to pay their bills, which might suggest a lack of liquidity or that the cash outflows are not being managed effectively.
DPO can vary between different industries since different industries have different payment practices.
For instance, businesses in the retail industry typically have a lower DPO than businesses that are a part of the construction industry.
Importance and Benefits of DPO
Here in the US, DPO is a significant financial metric that gives insight into a business’ financial operations and performance.
It also reveals the standing of the business in the industry.
Here are some of the reasons why DPO is important and beneficial for business:
1. Cash Flow Management
DPO can help businesses understand their cash flow better as it reveals how long it takes for them to make payments.
By analyzing and tracking this metric, business owners can better plan their cash flows and have funds available as and when required.
This helps businesses avoid cash flow shortages and ensure that they have enough financial resources to invest in their growth.
2. Supplier Relationships
A high DPO means that the business is delaying payments to its trade creditors, which includes its suppliers.
This can harm the relationship between the business and its suppliers. In the future, suppliers may be less willing to extend credit if the business continues to take longer to pay its bills.
By making better cash flow management decisions based on the DPO, the business can help maintain its relationship with its suppliers and ensure a steady supply of goods and services.
3. Financial Planning
Days payable outstanding also plays a role in a business’ financial planning and forecasting.
By tracking and analyzing the DPO, businesses can better understand their financial position and make more informed decisions about necessary requirements.
This can help businesses to not only avoid any financial problems but also plan for their future growth.
4. Working Capital Management
DPO is among the most important components of working capital management. Working capital management is the management of a business’ current assets and liabilities to ensure its ability to continue operating.
Businesses with a high DPO can indicate that they are taking too long to pay their bills, which could negatively affect their working capital as well as their overall financial health.
Lenders and investors can use the DPO to understand and evaluate a business’ creditworthiness.
A low DPO can be an indicator that the business has a good financial position. Whereas a high DPO can easily become a red flag for lenders and investors as it indicates that the business is struggling with cash flow problems.
By paying the bills on time, a business is likely to have a better credit rating. This makes it easier for the business to secure almost any type of financing in the future.
6. Negotiating Power
A business that is known to pay its bills on time has more negotiating power with its suppliers than those businesses that do not.
Having more negotiating power also means that the business can negotiate longer payment terms, which will not strain its cash flow.
This can also lead to better pricing and more favorable terms during negotiations in the future.
By tracking and analyzing the DPO, a business can improve its financial health and make better-informed decisions about cash outflows.
How to Calculate Days Payable Outstanding
In simple terms, divide the average accounts payable by the cost of goods sold (COGS) or the average daily purchases and multiply by the number of days in a year to determine DPO.
Formula for DPO DPO = (Accounts Payable ÷ Cost of Goods Sold or Average Daily Purchases) x 365
- Accounts payable is the amount of money owed to the suppliers for the goods and services received but not yet paid for,
- Cost of goods sold (COGS) is the cost of goods or services that the business sold during a specific period of time, and
- Average daily purchases is the average amount spent by the business on goods or services during a specific period.
Steps to Calculate DPO Here are steps to calculate the days payable outstanding:
Step 1: Determine the Average Accounts Payable Take the sum of the business’ accounts payable at the end of each quarter or month and divide the total by the number of days.
Step 2: Determine the COGS or Average Daily Purchases This is the amount spent by the business on goods or services during a specific period.
Step 3: Calculate the Average Payment Period For this, divide the average accounts payable by the COGS or average daily purchases.
Step 4: Multiply the Average Payment Period by 365 This will give you the DPO, which represents the average number of days it takes for a business to pay its bills or invoices.
To help you understand this better, let’s look at an example: A company by the name of Sam Ltd. has an average account payable of $100,000, and the COGS is $500,000. The average payment period would then be calculated as follows:
Average payment period: $100,000 ÷ $500,000 = 0.2 To calculate the DPO, multiply the average payment period by 365: DPO = 0.2 x 365 = 73
Sam Ltd. will take an average of 73 days to pay its bills.
However, note that the DPO can vary from industry to industry, so it is advisable to compare a business’ DPO with its fellow businesses in the industry to get a more accurate picture of the business’ financial performance.
Moreover, the DPO of a business may change over time, so it is crucial to keep tracking the metric on a regular basis to get a better understanding.
Factors Impacting DPO
In the US, DPO can vary based on the industry the business is a part of. However, there are many other factors that impact DPO, such as:
1. Payment Terms
One of the deciding factors in the DPO is the payment terms agreed upon with the suppliers.
For instance, if a business has agreed to pay the bill in 30 days, then the DPO would be 30.
But if the business agreed to pay the bill in 60 days, then the DPO would be 60.
In this case, the days payable outstanding is high, but it doesn’t necessarily mean that the business is going through any cash flow problems.
The payment terms with the supplier are highly dependent on the business’ creditworthiness.
If a business has a strong credit rating, it might be able to negotiate longer payment terms with the supplier, which would increase its DPO.
However, if a business has a poor credit rating, then the business will have to pay the bills faster, decreasing its DPO.
3. Cash Flow
A business’ cash flow has a strong influence on its DPO. If a business has a strong cash flow, then it may be able to pay its bills slowly, which would increase its DPO.
If it has a weak cash flow, then it may need to pay the bills quickly, leading to a decreased DPO.
The industry to which a business belongs also plays an important role in determining the DPO of that business.
For instance, there are many industries that have longer payment terms due to the nature of the products or services being provided.
5. Company Size
Larger businesses may have more negotiating power and can negotiate longer payment terms, which would increase their DPO.
6. Economic Conditions
Economic conditions, such as recession or inflation, can have a significant impact on a business’ DPO.
For instance, during a recession, businesses may have to pay their bills more quickly due to the shortage of cash, which would then result in a decreased DPO.
By understanding and tracking these factors, businesses can plan their cash flow better and make better informed financial decisions.
Various Techniques for Managing DPO
To avail the above-mentioned benefits, the key is effective management of DPO, which can be done using the following techniques:
1. Negotiate Longer Payment Terms
A business can negotiate longer payment terms with its suppliers to improve its cash flow. This will reduce the pressure on the business to pay bills quickly and improve its financial flexibility.
2. Implement an Automated Accounts Payable System
Using an automated accounts payable system can help businesses to manage their DPO more efficiently and effectively.
The system can help businesses to streamline the bill payment process, ensure that the bills are paid on time and provide valuable insights into their payment patterns.
3. Take Advantage of Early Payment Discounts
Some suppliers offer early payment discounts. Using these to their benefit, businesses can improve their DPO significantly.
They can reduce their costs and improve their cash flow.
4. Regularly Review Supplier Contracts Regularly reviewing supplier contracts can help businesses to understand their payment obligations better and also help them negotiate more favorable terms in the future.
5. Monitor Cash Flow Keeping track of the cash flow gives an insight into a business’ financial position and helps them make informed decisions about when to pay bills.
This practice can help businesses to avoid cash flow-related problems and ensure that they have funds available when they need them.
6. Improve Working Capital Management Ensuring the effective management of working capital can help improve a business’ DPO.
Improvement of the cash conversion cycle can reduce the time a business takes to pay its bills and improve its financial flexibility.
Using these various techniques to manage DPO better is beneficial for businesses in the long run.
Analysis of DPO
Regularly tracking and analyzing the DPO is important for businesses as it improves cash flow management, strengthens relationships with suppliers and helps better plan financial goals.
All of these contribute to an increase in negotiating power, improving cash flow, strengthening credit rating and making better financial decisions overall.
Moreover, DPO also impacts a business’ compliance with regulations.
By regularly tracking DPO, businesses can ensure that they are meeting their payment obligations. This will help them avoid any legal and financial penalties.
DPO Vs DSO
What is DSO?
Another financial metric like DPO is days sales outstanding (DSO).
It measures the average number of days it takes for a business to collect payment after a sale has been made.
DSO is a measure of the effectiveness of a business’ credit and collections management.
The formula for calculating DSO is:text in italic DSO = (Accounts Receivable / Total Credit Sales) x Number of Days in the Period
- Accounts receivable is the amount of money owed to the business by its customers for goods or services it sold but yet not paid for,
- Total credit sales is the total amount of sales made on credit during a specific period, and
- Number of days is the number of days in the period being measured, usually a month or a quarter.
In the United States, a low DSO indicates the business is collecting payments quickly and efficiently, whereas a high DSO suggests that the business is having trouble collecting payments on time, which can lead to cash flow problems.
A business should regularly monitor its DSO and take actions, if necessary, to reduce it.
Is DSO a Good KPI?
DSO can be a good key performance indicator (KPI) for a business as it provides insights about the efficiency of the business’ credit and collection management.
By measuring the average number of days a business takes to collect its payment, DSO provides valuable information about a business' ability to convert its accounts receivable into cash.
However, it is important to note that DSO is just one of the many KPIs that can be used to track, understand and analyze a business’ financial performance.
Other KPIs, such as accounts receivable and turnover and average payment period, can provide more insight that may support or not support the information provided by DSO.
Moreover, the usefulness of DSO as a KPI is highly dependent on the industry and the business.
DPO vs DSO
Days Payable Outstanding (DPO) and Days Sales Outstanding (DSO) are both financial metrics that measure the average length of time it takes for a business to collect or pay its debts.
However, they measure different aspects of a business' financial performance: DSO measures the average number of days it takes for a business to collect payment after a sale has been made.
It provides information about the efficiency of the business' credit and collections management, and a high DSO value may indicate that the business is having difficulty collecting payments on time.
DPO, on the other hand, measures the average number of days it takes for a business to pay its bills after they are due.
It provides information about the business' ability to manage its cash flow, and a high DPO value may indicate that the business is facing cash flow problems and has a lack of liquidity.
Generally, a low DSO and a high DPO are both desirable, as they indicate that a business is collecting payments quickly and paying its bills slowly, which can help to improve its cash flow.
However, there is a trade-off between DSO and DPO. A business that improves one metric may negatively impact the other.
For example, if a business starts collecting payments more quickly (reducing DSO), it may need to pay its bills more quickly as well (reducing DPO), which would negatively impact its cash flow.
Is DSO the same as the Average Days to Pay?
DSO measures the average number of days it takes for businesses to collect payments after a sale has been made.
This financial metric provides information about the efficiency of businesses' credit and collections management.
Average days to pay, on the other hand, measures the average number of days it takes for businesses to pay their bills after they are due. It provides information about businesses' ability to manage their cash flow.
Both metrics are important for understanding a business' financial performance and cash flow, but they provide different types of information and should be considered separately.
What is a Good DSO score?
The definition of a "good" DSO score depends on a number of factors, including the industry, the size of the business, and the business' own financial goals and objectives.
Generally, in the US, a low DSO score is considered to be good, as it indicates that the business is collecting payments quickly and efficiently.
A DSO score of 30 days or less is often considered to be very good, as it means that the business is collecting payments within a month of making a sale.
However, it is important to keep in mind that a low DSO score is not always achievable or desirable, as businesses may need to offer longer payment terms to their customers in order to compete or to support sales growth.
In such cases, it may be more appropriate to compare the business' DSO score to other businesses in the industry or to track changes in the DSO score over time.
Days payable outstanding is an important financial metric that is also the key performance indicator (KPI) for a business as it provides valuable insights into its ability to pay its bills on time.
It can also help businesses to better understand their financial position as well as assess their liquidity position.
It is a significant metric for businesses as it gives detailed insight into their cash flow management, supplier relationships, financial planning, working capital management and creditworthiness.
Regular tracking and analyzing of DPO can help businesses to improve their cash flow and plan their finances better.
Is a Higher or Lower DPO Score Better?
Typically, a higher DPO is considered to be better, as it indicates that the business is taking advantage of its suppliers' payment terms to improve its own cash flow.
A high DPO score means that the business is paying its bills more slowly, which can help to free up cash that can be used for other purposes, such as investments or debt repayment.
But keep in mind that there is a trade-off between DPO and other financial metrics, such as the business' relationships with its suppliers and its credit score.
Businesses that take too long to pay their bills may damage their relationships with their suppliers, which could lead to higher costs or reduced access to credit in the future.
What Causes a DPO to Decrease?
A decrease in DPO can result from a variety of factors, including improved cash flow, changes in the payment terms, increased pressure from the suppliers, changes in the credit policies and improved accounts payable process.
It is vital to consider these factors when evaluating changes in DPO, as they can provide insight into the business' overall financial performance.
What is the Ideal Relationship Between DPO and DSO?
The relationship between DPO and DSO is an important factor to consider when evaluating a business' financial position.
A business with a high DPO and a low DSO is considered to have a favorable cash flow, as it is taking advantage of its suppliers' payment terms to improve its own cash flow, while also collecting payments quickly and efficiently.
This can help the business to maintain a strong financial position, even if sales are not growing rapidly.
However, the ideal relationship between DPO and DSO will vary depending on the business' specific financial goals and objectives.