Thursday, August 6

Days Payable Outstanding (DPO)

The days payable outstanding (DPO) is a financial ratio which computes the average time it requires a business to pay its own bills and bills to other business and sellers by assessing accounts payable, cost of revenue, and amount of times invoices remain outstanding.

Definition – What is Days Payable Outstanding (DPO)?

In other words, DPO signifies the normal number of times a company requires to pay bills from suppliers and sellers. Normally, this ratio will be measured on a quarterly or yearly basis to gauge how well the firm’s money flow accounts are being handled. As an example, a business that takes more time to cover its invoices has access to the money for a longer duration and can do much more things with it throughout this period.

For instance, allow’s presume Company A buys raw material, utilities, and solutions from the vendors on credit to produce a product. This account or credit 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 day payable outstanding formula is calculated by dividing the accounts payable by the derivation of the cost of sales and the average number of days outstanding. Here’s what the equation looks like:

Days Payable Outstanding (DPO) Example

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 buy that was made on credit. This total number is 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 is sold to the customer. It includes all direct costs such as raw material, utilities, transportation cost, and rent directly applicable to manufacturing. This is 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:

Days Payable Outstanding (DPO) Example

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 equal-cost ).

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 marketplace leader with significant buying 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 marketplace 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)

DPO Equation Calculation

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 obtain mad that they aren’t be compensated and refuse to conduct business with the business or refuse to provide reductions. Days payable outstanding walks the line between enhancing business cash flow and maintaining sellers contented.

It’s important to always compare a business’s DPO to additional businesses in precisely the equal sector to find out whether this provider is paying its own bills too fast or too slowly. If a provider is paying bills in 20 days and the business is paying them 45 days, the business is at a disadvantage since it isn’t able to utilize its money provided that the other firms in its sector. It can wish to lengthen its own payment intervals to enhance its cash flow so long as this doesn’t mean losing an early payment discount or hurting a vendor interrelation.

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 is 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 cycles).

Investors also compare the current DPO with the company’s own historical range. A consistent decline in DPO might signal towards changing product mix, gained competition, or reduction in buying power of a company. For example, Wal-Mart has historically had DPO as high as 44-46 days, but with the development in a 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 many to spoil the interrelation completely. A company can employ several techniques to improve DPO, few of them are

1) Identify products with the 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 imply that the provider is operating more economically. The reduce business may be getting more positive early pay reductions compared to another firm and so they always pay their bills prematurely.

It’s vital that you keep each these matters in mind when assessing the day exceptional payable ratio.