The days payable outstanding (DPO) is a financial ratio that calculates the average time it takes a company to pay its bills and invoices to other company and vendors by comparing accounts payable, cost of sales, and number of days bills remain unpaid.
Definition – What is Days Payable Outstanding (DPO)?
Contents
In other words, DPO means the average number of days a company takes to pay invoices from suppliers and vendors. Typically, this ratio is measured on a quarterly or annual basis to judge how well the company’s cash flow balances are being managed. For instance, a company that takes longer to pay its bills has access to its cash for a longer period and is able to do more things with it during that period.
For example, let’s assume Company A purchases raw material, utilities, and services from its vendors on credit to manufacture a product. This credit or accounts payable isn’t due for 30 days. This means that the company can use the resources from its vendor and keep its cash for 30 days. This cash could be used for other operations or an emergency during the 30-day payment period. DPO takes the average of all payables owed at a point in time and compares them with the average number of days they will need to be paid.
The importance of DPO becomes obvious. A company with a high DPO can deploy its cash for productive measures such as managing operations, producing more goods, or earning interest instead of paying its invoices upfront.
Let’s take a look at the equation and how to calculate DPO.
Formula
The days payable outstanding formula is calculated by dividing the accounts payable by the derivation of cost of sales and the average number of days outstanding. Here’s what the equation looks like:
Days Payable Outstanding = [ Accounts Payable / ( Cost of Sales / Number of days ) ]
The DPO calculation consists of two three different terms.
Accounts Payable – this is the amount of money that a company owes a vendor or supplier for a purchase that was made on credit. This total number can be found on the balance sheet.
Cost of Sales – this is the total cost incurred by the company in manufacturing the product or bringing the product to a level at which it can be sold to the customer. It includes all direct costs such as raw material, utilities, transportation cost, and rent directly applicable to manufacturing. This can be found on the income statement of a company.
Number of days – this is the actual number of days that the account payable and cost of sales in based (for example 365 days).
Let’s take a look at a DPO example.
Example
Ted owns a clothing manufacturer that purchases materials from several vendors. At the end of the year, his accounts payable on the balance sheet was $1,000,000. On average, he paid $15,000 ( $5,475,000 / 365 days ) of invoices each day. Ted would calculate his DPO like this:
This means that Ted pays his invoices 67 days after receiving them on average.
Now let’s make the example a little more complicated and include money that Ted will collect from customers. Here are some terms from his latest purchases from vendors and sales to customers.
- Accounts Payable: $100
- Due date of A/P: 10 days
- Accounts receivable from sales to customers: $100
- Due date of A/R: 5 days
In the above, over simplified example, we are assuming that Ted has to pay $100 in 10 days to his vendors and he will receive $100 from his customers in 5 days. So the net impact of these transactions will be that the company can hold on to $100 for 5 days. Hypothetically, if the interest rate is 1 percent, then in 5 days the company can earn $1 (1% of $100 in 5 days) without even charging a margin to its customers (remember the company bought goods for $100 and sold the finished product for the same price).
There are several factors at play which define the level of DPO, primary among them are:
1) Type of industry
2) Competitive positioning of a company – A market leader with significant purchasing power can negotiate favorable terms with its supplier so as to have a very high DPO.
3) Competitiveness – if there are many suppliers with little differentiation than they will have to offer longer payment cycle to gain business from a client.
Ultimately, the DPO may depend on the contract between the vendor and the company. The vendor might offer discounts for early payment. In that case, the company will have to weigh the option of holding on the cash versus availing the discount.
Let’s look at a Real World Example
Consider the case of Wal-Mart and Tesco. These retail giants have significant market clout, which allows them to negotiate better deals with their suppliers and pay as late as possible. In the case of Wal-Mart the DPO has hovered around 38- 39 days for last 3-4 years, implying that Wal-Mart might be typically paying its suppliers after more than a month of sourcing the products from them. On the other hand, Tesco has a DPO of ~60 days, implying two month lag in payment to suppliers. Days Payable Outstanding (unit – number of days)
Analysis and Interpretation
DPO is an important financial ratio that investors look at to gauge the operational efficiency of a company. A higher DPO means that the company is taking longer to pay its vendors and suppliers than a company with a smaller DPO. Companies with high DPOs have advantages because they are more liquid than companies with smaller DPOs and can use their cash for short-term investments.
A high ratio also has disadvantages. Vendors and suppliers might get mad that they aren’t being paid early and refuse to do business with the company or refuse to give discounts. Days payable outstanding walks the line between improving company cash flow and keeping vendors happy.
It’s important to always compare a company’s DPO to other companies in the same industry to see if that company is paying its invoices too quickly or too slowly. If a company is paying invoices in 20 days and the industry is paying them in 45 days, the company is at a disadvantage because it’s not able to use its cash as long as the other companies in its industry. It may want to lengthen its payment periods to improve its cash flow as long as this doesn’t mean losing an early payment discount or hurting a vendor relationship.
Talking about Wal-Mart, it has a DPO of 39 days, while the industry average is for example 30 days. This might imply that Wal-Mart has been able to negotiate better terms with the suppliers compared to the broader industry. We need to be careful while selecting the peers for comparison. DPO can be impacted by product mix (for example Amazon might have very high DPO because of its historical business of books which tend to have longer payment cycle).
Investors also compare the current DPO with the company’s own historical range. A consistent decline in DPO might signal towards changing product mix, increased competition, or reduction in purchasing power of a company. For example, Wal-Mart has historically had DPO as high as 44-46 days, but with the increase in competition (especially from the online retails) it has been forced to ease the terms with its suppliers.
Usage Explanations and Cautions
A company has to maintain the delicate balance of improving DPO and not pushing its supplier too much to spoil the relationship completely. A company can employ several techniques to improve DPO, few of them are
1) Identify products with shortest DPO and formulating ways to improve the DPO of that product either by re-negotiating with the supplier or changing suppliers
2) Change product mix
3) Internal restructuring of the operations team to improve the efficiency of payable processing.
In conclusion, Days Payable Outstanding (DPO) is a key metric to analyze the operational efficiency of a company and can act as an important source of generating extra returns for the investors, but it should always be viewed relative to the industry and product mix. For example, just because one company has a higher ratio than another company doesn’t mean that company is running more efficiently. The lower company might be getting more favorable early pay discounts than the other company and thus they always pay their bills early.
It’s important to keep all of these things in mind when analyzing the days outstanding payable ratio.
