The Days Payable Outstanding (DPO) ratio shows the average number of days it takes a company to pay its own outstanding invoices. It’s sort of the flip side of DSO, or Days Sales Outstanding. Increasing DPO improves working capital and increases free cash flow.
DPO is impacted by both contractual terms (when are we invoiced?) and by the promptness of our payment (did we pay the invoice on time?). The shorter the number of days payable outstanding, the more expensive it is, because we don’t have the cash, and we may have to borrow to pay our own bills. The longer our DPO days, the better we are managing our cash, and the more flexibility we have to invest in our own business.
The formula for Days Payable Outstanding is:
The numerator of this ratio is ending accounts payable, taken from the balance sheet at the end of the period you’re looking at. For our example, let’s assume it’s $1,200.
The denominator of DPO is Cost of Goods Sold (COGS) per day. This tells us how much inventory is actually used each day. COGS is found on the income statement. To get a daily number, divide COGS by the number of days in a year. (Financial folks tend to use 360 as the number of days in a year, simply because it’s a round number.) For example, if the income statement for year 2 shows COGS of $7,200, you would determine the inventory consumed per day as:
COGS per day = $7,200 / 360 = $20
To complete the DPO calculation:
DPO = $1,200 / $20 = 60
In other words, it takes this company an average of about 60 days to pay their bills. This company’s suppliers have to wait almost two months to get paid. This lengthy time span may be good for working capital but not good for supplier relationships.
(Excerpts from Financial Intelligence, Chapter 24 – Efficiency Ratios)
The higher the DPO, the better a company’s cash position, but the less happy its vendors are likely to be. A company with a reputation for slow pay may find that top-of-the-line vendors don’t compete for its business quite so aggressively as they otherwise might. Prices might be a little higher, terms a little stiffer. A company with a reputation for prompt thirty-day payment will find the exact opposite. Watching DPO is a way of ensuring that the company is sticking to whatever balance it wants to strike between preserving its cash and keeping vendors happy.