Say a company received a standard invoice from a varnish manufacturer from whom it bought varnish to recoat wooden surfaces and desks in the office. Part of the terms of the transaction will be a date by which a vendor will want or expect payment and a date by which the company would like to or be able to make the payment.
By calculating days payable outstanding, a vendor, supplier, or any business analyst can know the average number of days between receiving the varnish invoice and when it would be paid.
What is days payable outstanding?
Days payable outstanding (DPO) is a financial metric used by businesses to track the efficiency of cash flow, meaning the amount of cash and cash equivalent flowing in and out of a business during a particular time.
Simply put, a DPO calculation shows how many days a business or company takes to pay suppliers and vendor invoices on average.
How to calculate DPO
DPO = (Ending accounts payable x No. of days in an accounting period) / Cost of goods sold
Use the above days payable outstanding formula to calculate DPO.
Ending accounts payable is the balance of accounts payable at the end of a particular period, like the end of a month or year. Accounts payable are the amounts a company owes to its creditors for goods or services it has received but has yet to pay for.
When a company closes its books for a particular period, it records the ending balance of its accounts payable. This balance is then carried forward to the next period as a starting balance. You can find a number associated with ending accounts payable on a company’s balance sheet.
Cost of goods sold (COGS) refers to the direct costs of producing a company's goods.
For example, cost of materials, labor, and other expenses related to production like office rent, supplies, and utilities. It typically won’t include indirect expenses like research and marketing, development, and administration.
A number associated with COGS will generally be in a company’s financial statement. COGS is a subset of total purchases. It only represents a portion of the total purchases made by a company.
In particular, companies report COGS on an income statement, a financial statement that shows a company’s revenues, expenses, and profits over a specific period, like a month or a year. An income statement may also be called a profit and loss statement.
High DPO versus low DPO
What’s considered high or low DPO varies widely by industry and business size. The average DPO of some of the largest US companies increased by 7.6% in 2020 to more than 62 days.
While determining the DPO of private companies can be difficult, it’s sometimes possible to calculate the DPO of public companies based on data in their financial statements. DPO does not always signal financial health, but some assumptions can be made.
A high DPO is usually considered favorable for a company. It could mean the business is taking advantage of the credit terms they are receiving from the supplier, keeping more cash on hand for business operations and short-term investments.
Extremely high DPOs can mean a business faces financial struggles and is having difficulties paying creditors on time. Taking too long to pay creditors can result in refusals to extend additional credit or offer favorable terms in future transactions.
Low DPO can also mean two things. It can indicate a company is not fully utilizing its credit period; therefore, missing out on potential short-term investment opportunities. Or, it’s possible the company only has short-term credit arrangements with its creditors. Some suppliers offer early payment discounts, which can lower DPO if businesses take advantage of them.
Why calculate days payable outstanding?
Days payable outstanding indicates the financial health of a company’s cash flow. It is an efficiency metric that can also be used to assess a company’s relationship with its suppliers.
A company that consistently pays its bills on time (low DPO) will likely have good relationships with its suppliers. This can benefit prospective suppliers interested in a steady supply of goods and materials towards negotiating favorable terms.
A company that takes a long time to pay its bills (high DPO) may be struggling to manage its cash flow and, as a result, may not be seen positively by creditors and investors.
Overall, calculating DPO is important because it helps companies, investors, and creditors understand how well a company manages its account payable and financial risk. It can show if a company can meet short-term debt obligations.
DPO calculation can help to identify issues in a business or operation that may need to be addressed. DPO isn’t always black and white. Investors, creditors, and other companies may be looking at your DPO for different reasons.
A low DPO could also be indicative of your company paying off invoices too fast. Yes, you'll have good supplier relationships and other benefits, but paying off invoices too fast can be a lost opportunity to invest the cash in other investments.
Example of DPO calculation
Here’s an example of how a company’s cash flow affects its DPO calculation. Let’s assume a company has the following information at the end of a calendar year ending Dec. 31:
- Accounts payable: $8,000
- Cost of goods sold: $95,000
To calculate DPO, we will divide the accounts payable balance by the total cost directly related to goods production, or cost of goods sold (COGS), and multiply by the number of days at the end of a year, aka 365.
DPO= 8,000 x 365 / 95000 = 30.7 or 31 days
This means that it takes the company an average of 31 days to pay its bills. Depending on the industry or business size, this DPO could be high, low, or average. Regardless, the company could then use this information to improve cash flow management.
If this was a high DPO ratio, it could be a cause for concern for creditors and investors as it suggests that the company might be at risk of defaulting on its obligations. A supplier might be concerned about a high DPO, too, because it could indicate that a company is not paying its bills on time which could negatively impact the supplier’s own cash flow.
Limitations of DPO
Sure, DPO can reveal information about a company’s financial health, but it is important that this metric is used in conjunction with other financial ratios and analyses to get a complete picture. This is because there are certain limitations inherent to DPO that must be taken into interpreting its results. For example:
- DPO only measures the time it takes a company to pay its bill. It does not take into account the terms of payment agreed upon between the company and its creditors/suppliers. For example, a company with a high DPO may have agreed to pay its bills in 90 days, whereas a company with low DPO may have agreed to pay its bills in 30 days. Some suppliers offer discounts for early payment.
- DPO does not take into account the company’s ability to pay its bills. For example, a company with a high DPO may have sufficient cash on hand to pay its bills when they are due but logistically takes a long time to do so.
- DPO is based on historical data that may not accurately reflect a company’s current financial situation.
- DPO does not take into account any seasonal fluctuations in a company’s business. For example, a company may have a high DPO during its slow season, but a lower DPO during its busy season.
It is important to consider other metrics and trends while calculating and analyzing a company’s financial health.
What is days sales outstanding (DSO)?
Days sales outstanding (DSO) is the name given to a financial metric that measures the average number of days it takes a company to collect payment from its customers.
It is calculated by dividing the company’s accounts receivable balance by its average daily sales and multiplying by the number of days in the per measured.
A high DSO could indicate that a company is having difficulty collecting customer payments. This could be a sign of financial risk.
On the other hand, low DSO could indicate that a company can collect payment from its customers efficiently, without much delay. This may be seen as a positive delay by creditors and investors.
DSO vs DPO
Both metrics provide insight into a company’s cash flow and financial risk but focus on different aspects of its operations. DSO measures how quickly a company can collect payment from its customers. DPO measures how quickly a company can pay its bills.
How to optimize days payable outstanding with BILL
One way to have healthy days payable outstanding with BILL is by automating your accounts payable, including approving bills and making payments. The accounts payable automation software allows users to cut bill pay time by 50 percent. It also allows users to get paid twice as fast as they did before from domestic and international vendors alike.
Take a guided video tour of how the software works and what it does or check out a summary below:
- Easily enter your bills: BILL’s automation software for accounts payable allows easy entry of bills and multiple ways to quickly import all your invoices into BILL. No manual entry is required.
- Bill approval policies: You can set BILL approval policies or guidelines using the software. For example, you can ask the software to approve all marketing bills above $10,000 for a specific vendor.
- Pay faster: Leverage multiple payment options from ACH to credit card, check, and international wire transfer to make payments.