How to Use the Days Payable Outstanding Metric to Calculate Working Capital and Meet Early Payment Discount Terms 041317

Days payable outstanding (DPO) is an efficiency ratio that measures the average number of days a company takes to pay its suppliers. It is important because it is a key component in a company's formula for calculating working capital. 

"However,” explains Wayne Smith, founder and president of Working Capital Concepts, LLC, “in order for data such as DPO to be of value, it must be used in a context and compared to other data, either internally or externally. It must also be used strategically so that companies can maintain the proper amount of working capital to pay for daily operations and to finance future growth." 

Formulas for Calculating DPO

According to Smith, DPO can be calculated in the following manner:

Exhibit 1: 

Trade payables (excluding accrued expenses)

cost of goods sold/365 

In the above formula. cost of goods sold is used in the denominator. However, instead of cost of goods sold, many organizations use sales in the denominator, he reveals.

Exhibit 2: 

Trade payables (excluding accrued expenses)

sales/365 

If you use published ratio data to compare your DPO to that of other companies or industries, you’ll need to use the same formula they are using. If you are using it internally, you can use whatever formula fits your needs. 

When comparing your organization to others, bear in mind that the published information is only a rough gauge, because other organizations will have a mix of different vendors and payment terms. 

"AP should be aware of its industry standard, the company's current DPO, and management's DPO goal so that they can take into consideration the effect AP's everyday actions have on DPO," says Smith. 

  • Case in point: Let’s say AP calculates DPO (using the method in Exhibit 2) and comes up with the number 40. This means it is taking AP 40 days on average to pay an invoice. In order for that metric to have some meaning, AP might look at the prior month or year and see that the previous number was 50. This demonstrates that AP has paid faster during the designated time period. 

While this appears to be a good result, it is not necessarily so if the vendor terms call for payment in 30 days. For example, in that case, with a DPO of 40, AP is paying invoices 10 days late on average. On the other hand, if the DPO is 20 and most vendor terms call for payment in 30 days, there may be little value in paying ahead of terms. 

"That is why ratios need to be used in context with other internal data or data from other companies for comparison," says Smith. "In addition, such ratios need to be calculated in a consistent manner." 

Regardless of how DPO is calculated in your company, it must be done in a consistent manner so that trends are meaningful. As mentioned, a high or rising DPO may be desirable and signify that your organization is enjoying favorable terms from creditors. A low DPO may indicate that a company is paying its creditors quickly. 

"Generally, it is best practice to negotiate extended credit terms and then pay on time with the allowable grace period, if any,” says Smith. “Accept discounts for early payment only if they are economical for your company."

Tips for Maintaining a Healthy DPO

Here are five tips from Smith to help your organization maintain a healthy DPO: 

  1. If a vendor states terms on the invoice, do not deviate from the stated terms.
  2. Make sure that your vendors are aware of the default terms you will use if no terms are indicated.
  3. Eliminate rush checks, since they will negatively affect DPO.
  4. Automate high-volume, low-value transactions to free up time for high-value suppliers and transactions.
  5. Make sure systems are in place that maximize the organization's DPO and are flexible and adaptable enough to change when necessary. 

Editor’s Note: Wayne Smith, an IOFM advisory panelist, is founder and president of Working Capital Concepts LLC and author of Mining the Ca$h Hidden in Your Business: Increase Cash Flow and Decrease Financing Requirements by Reducing Working Capital. For more information, contact wayne@workingcapitalconcepts.com.

How to Use the Days Payable Outstanding Metric to Calculate Working Capital and Meet Early Payment Discount Terms 041317

 
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