Days Payable Outstanding
What is Days Payable Outstanding?
Before defining DPO, it pays to first explore the definition of accounts payable (AP). Accounts payable is an accounting term describing inventory, services, and materials that an organization acquires on credit. AP represents the short-term liabilities that a business needs to pay back to its creditors. DPO is a measurement of how long the business takes to make those payments.
The definition of DPO is usually explained as a financial ratio calculated on a quarterly or annual basis that is used to determine the average number of days it takes a particular organization to pay its bills and invoices. Knowing an organization’s DPO allows creditors such as vendors, suppliers, and financiers to evaluate how many days a company takes to pay for their services. (That is why DPO is sometimes also known as “creditor days” or simply “accounts payable days.”) It can also provide a good idea of how well a business is managing its finances, particularly its cash outflows.
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Understanding the concept of days payable outstanding (DPO) is essential for any organization that regularly deals with invoices. Being able to calculate DPO provides useful insights into a company’s financial practices and can have a major impact on vendor relationships in both the short and the long term. Let’s look more closely at the principles behind calculating DPO and what it can mean for your business.
What Does a High DPO Mean for a Business?
An organization with a higher value of DPO generally takes longer to pay its suppliers than one with a low DPO. That may seem like a red flag for potential vendors, but making payments over a longer period of time can actually be a positive indicator. In many instances, a company with a relatively high DPO may be delaying making payments in order to keep a larger amount of cash on hand. That allows an organization to get stronger benefits from those funds, including making short term investments and boosting the level of working capital. That kind of freedom ultimately benefits both the organization and its suppliers.
On the other hand, sometimes it is possible to judge a book by its cover. A high value DPO can also indicate that a company has not been paying its bills in a timely fashion simply because it does not have enough money on hand. It is not always easy to know whether an organization’s high DPO signifies a strong financial plan or a serious cash shortfall, but determining the difference is of vital importance for potential suppliers.
How to Calculate Days Payable Outstanding
Let’s go a little deeper into the process of calculating DPO for a specific organization. From an accounting standpoint, accounts payable needs to keep track of the cost of all of the elements that go into bringing a sellable product or service to market. That includes basics such as raw materials and utilities as well as manufacturing costs such as employee wages, equipment, and upkeep on facilities. Taken all together, these elements make up the Cost of Goods Sold (COGS).
Basically, the Cost of Goods Sold represents how much it costs a business to manufacture or otherwise acquire the products it sells over a specific accounting period, usually either 90 or 365 days depending on whether your accounting periods are quarterly or annual. Essentially, the goal here is to determine how much it costs per day, on average, for a company to manufacture or produce a product, the amount of outstanding payments. Once you know those figures, you can use them to determine the average number of days your organization takes to pay suppliers once their bills and invoices have been received.
What is the Formula for Calculating DPO?
The basic formula for calculating an organization’s DPO is as follows:
(Average Accounts Payable x Number of Days in Your Accounting Period) / Cost of Goods Sold = DPO
Cost of Goods Sold (COGS) is defined as the Beginning Inventory plus Purchases, minus the Ending Inventory
An alternate and equally valid formula for calculating DPO looks like this:
Average Accounts Payable / (Cost of Sales / Number of Days in Your Accounting Period) = DPO
Cost of Sales is defined as the Beginning Inventory plus Purchases, minus the Ending Inventory.
For example, if a business posts a Average Accounts Payable balance of $500,000 over a 365-day period with a $4 million COGS, the DPO could be calculated as (500,000 x 365) / 4,000,000. The DPO in this case would be 45.625 days, which is generally regarded as a very good DPO.
Why Should You Calculate Days Payable Outstanding?
There are a number of reasons that calculating DPO can benefit both the organization in question and its suppliers and vendors. DPO provides penetrating insights into a company’s accounts payable performance and helps your AP team make adjustments and process changes for the future. A few of the key insights DPO calculations can reveal include:
Understanding your organization’s cash flow
One of the biggest issues an accurate DPO calculation can help to address is a lack of visibility into the flow of cash in and out of your organization. Let your accounts payable balance get too high and you may start seeing unpaid bills piling up and creditors losing patience. On the other hand, if your accounts receivable total gets too high, you may be looking at cash shortages that can impact budgeting across your business and leave you empty-handed in the event of a financial emergency. Calculating DPO helps you to maintain an accurate balance sheet that makes sure that neither accounts payable nor accounts receivable go beyond your comfort zone.
Understanding the implications of a high DPO
It can be easy to misinterpret a high DPO, since it generally means that a business takes a comparatively long time to pay back its creditors. That might seem like a red flag to a layperson, but in fact there are many situations in which taking longer to make payments is a good thing for both the business. Many organizations strive to keep their DPOs relatively high, because it allows that cash to be used on short-term investments, supply chain management, contract renegotiations, and other key tasks that require quick infusions of cash.
Understanding the implications of a low DPO
Conversely, a low DPO might look desirable to a casual observer, because it nominally indicates a business that pays its bills in a prompt fashion. While this is often the case, a low DPO is sometimes seen as a warning sign for creditors. Too low of a DPO may lead potential vendors and suppliers to assume that an organization pays its bills so quickly because of poor credit that makes cautious creditors set strict credit terms or demand immediate payment. Whether or not that assumption is true, the appearance of liability can be just as damaging as the real thing when it comes to procuring vendor services.
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Whether your organization is striving for a high or low DPO, it is important that you and your creditors come to a mutual agreement about payment terms. Different vendors and suppliers have different ideas about what constitutes favorable terms. While one vendor might see your high DPO as a sign of a healthy company with a strong financial plan, another may simply see it as a sign of a company that takes too long to pay its bills. That is not a reputation any business wants to cultivate, especially in high-volume industries where discounts for early payment can have a serious impact on your bottom line.
Ready to learn more about the ways accounts payable automation solutions from MHC can help your organization get a better handle on managing DPO and other key AP tasks? Contact us today to schedule a demonstration of MHC AP software solutions!
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