Days payable outstanding (DPO) are the days taken by a company to clear its accounts payable. It also indicates how long a company takes to convert its raw material into finished goods and utilize that cash to pay its creditors.
Several factors affect the DPO figure. A company can have a high or a low DPO figure. There are no set rules to define a perfect DPO figure though.
Let us discuss what are days payable outstanding and how to calculate them.
Days Payable Outstanding (DPO) – Definition
Days payable outstanding or simply DPO is an accounting term used for the time taken by an entity to clear its accounts payable.
Accounts payable is an accumulation of payable amounts for its credit accounts. For an entity, the accounts payable are accumulated balances for its important stakeholders. These stakeholders include suppliers, creditors, vendors, and franchisers.
DPO is calculated using an average figure. For instance, if a company has a DPO of 30 days, it means the company takes 30 days on average to clear its accounts payable. There are no set rules to define a static figure for a DPO calculation.
It’s important to consider that the DPO figure may also vary by industry and other factors (discussed in detail below). Therefore, there are no specific rules to determine the right DPO figure.
A company can use trend analysis and benchmarking to determine whether it operates a high or a low DPO.
How Do Days Payable Outstanding (DPO) Work?
Every business makes purchases to manufacture products or offer services. Most businesses do have accounts payable. It means they make purchases on credit terms from suppliers and vendors.
The term DPO means the time taken on average to clear accounts payable by an entity. As long as the company does not clear accounts payable, it is utilizing these funds. Therefore, it also means that a longer DPO period helps a company fulfill its cash needs.
Let us first see the two widely used formulas to calculate DPO.
Formula
Days Payable Outstanding = (Average Accounts Payable / Cost of Goods Sold) x Number of Days in Accounting Period
Or
Days Payable Outstanding = Average Accounts Payable / (Cost of Sales / Number of Days in Accounting Period)
Cost of sales = beginning inventory + Purchases – ending inventory
The number of days in the accounting period = 365 for annual calculations and 90 for quarterly calculations.
The numerator of both formulas is the accounts payable figure. For accounting consistency, most companies use the average outstanding payable amount for these formulas.
The DPO figure can be calculated at any given time. For instance, the DPO figure can be calculated at the end of the year or during an accounting period using beginning and ending inventory figures. However, an entity must define the annual or quarterly period to clearly interpret the results.
How to Calculate Days Payable Outstanding (DPO)?
You can use a step-by-step approach to calculate the days payable outstanding using figures from the balance sheet of a company. The information is readily available for publicly listed companies.
We can use both variations of the formula given above using the cost of goods sold or using sales figures.
STEP 01:
The first step is to calculate the average accounts payable figure. You can calculate this by using the beginning and ending accounts payable balances for the accounting period. Deduct the ending AP figure from the beginning AP figure and divide it by 2.
STEP 02:
The next step is to calculate the cost of goods sold for the same accounting period. This figure can be calculated by using the equation:
Cost of Goods Sold = Beginning Inventory + New Purchases – Ending Inventory
The inventory figures relate to the cost of goods sold directly.
If you are using the second formula, calculate the cost of sales figure instead of COGS. Cost of sales can be calculated using the same formula as COGS. You should ensure to separate any irrelevant costs from the cost of sales.
STEP 03:
The third step is to simply put figures into the first part of the formula. Divide the average accounts payable figure by the cost of goods sold or the cost of sales figure.
STEP 04:
Finally, divide the resulting amount by annual or quarterly days figure and you’ll have the days payable outstanding at hand.
Examples of Days Payable Outstanding Calculations
Suppose a company ABC has an accounts payable balance of $700,000 in its balance sheet. The cost of goods sold for the company is $1,000,000 on its income statement.
The company uses an annual or 365 days as the accounting period for its calculations.
We can calculate the days payable outstanding for ABC Company using the formula:
Days Payable Outstanding = (Average Accounts Payable / Cost of Goods Sold) x Number of Days in Accounting Period
Days Payable Outstanding = $700,000/ ($1,000,000/365) = 255 days
Suppose the company ABC has an average (AP) accounts payable of $ 80,000 for its last quarter.
It has the following inventory figures:
- Beginning inventory = $ 300,000
- New Purchases = $ 1,500,000
- Ending inventory = $ 100,000
Therefore,
Cost of Sales = $300,000 + $ 1,500,000 – $1,00,000 = $1,700,000.
Now we can use the DPO formula:
Days Payable Outstanding = Average Accounts Payable / (Cost of Sales / Number of Days in Accounting Period)
Days Payable Outstanding = $ 80,000/ ($1,700,000/90) = 4.23 days
Importance of Days Payable Outstanding Calculations
We have seen two contrastingly different figures in our calculations above. It’s important to understand the basic difference for both calculations is the average AP and the number of days used for the formula is annual and quarterly respectively.
Once you have these figures, you can compare them with the internal historic records. For example, suppose company ABC had an average DPO of 180 days for the previous year as compared to 255 days for the current year.
Similarly, in our second example, suppose the company ABC had an average DPO of 15 days for the previous quarter as compared to 4.23 days for the current quarter.
In the same way, company ABC can set benchmarks and compare its performance in terms of DPO.
Interpretation of High and Low Days Payable Outstanding
Companies would like to see a high DPO average generally. Foremost, it means that the company can utilize the funds for a longer period than it has to pay to its creditors otherwise.
A high DPO also suggests that a company maintains good credit terms with its suppliers and vendors. Thus, it can help a company beat its competitors through better utilization of inventory purchases.
Conversely, if a company maintains a too high DPO for too long it means the company is facing cash flow problems. Taking too long to clear accounts payable can put a company under financial distress and liquidity issues as well.
A low DPO means either a company is not properly utilizing credit terms or it lacks better credit terms offered by its creditors. Either way, a too-short DPO is not good for the financial health of any business.
Contrarily, if a company consistently maintains a low DPO it may also mean that it enjoys a good liquidity balance and has surplus cash at its disposal.
Also, it is important to mention that DPO figures should be compared for the companies within the same industry and of similar sizes.
For example, a business in the retail industry such as Walmart will maintain a typically higher DPO. A tech company like Apple or Facebook would maintain a low DPO. Similarly, some business models like Amazon would see inevitably longer DPOs than other businesses.
In short, the best way to analyze the DPO of a company is to compare the figures with internal historic records and establish a trend. Otherwise, the benchmarking standards should be set carefully and within the competitors’ industry to analyze objectively.
Factors Affecting Days Payable Outstanding
Analyzing the DPO formula can help us understand different factors affecting the DPO.
The DPO formula has average accounts payable figure in its numerator. The higher the average AP the longer will be the DPO. It means if a company maintains extended accounts payable periods, it will take longer to clear its dues.
Similarly, in its denominator, we have the average cost of goods sold and cost of sales figures. These figures depend on credit terms with the suppliers and vendors of a company.
Also, the operational efficiency of a company plays an important role. If a company is efficiently converting raw materials into finished goods and receiving cash quickly, it will be able to clear its accounts payable faster.
As we mentioned above, the industry and size of a company also affect the average DPO of a company. Some industries such as retails, transportation, or distribution will inevitably have longer DPOs than other industries.
Credit terms with creditors including suppliers and vendors would also play a major role in the calculations of the average DPO.
