Days Payable Outstanding (DPO) refers to the average number of days it takes a company to pay back its accounts payable. Therefore, days payable outstanding measures how well a company is managing its accounts payable. A DPO of 20 means that, on average, it takes a company 20 days to pay back its suppliers.
Days Payable Outstanding Formula
The formula for DPO is as follows:
Days Payable Outstanding = (Average Accounts Payable / Cost of Goods Sold) x Number of Days in Accounting Period
Days Payable Outstanding = Average Accounts Payable / (Cost of Sales / Number of Days in Accounting Period)
Let us consider the implications of a high and low DPO:
A high DPO is generally advantageous for a company. If a company takes longer to pay its creditors, the excess cash on hand could be used for short-term investing activities. However, taking too long to pay creditors may result in unhappy creditors and their refusal to extend further credit or offer favorable credit terms. Also, if the DPO is too high, it may indicate that the company is struggling to find the cash to pay its creditors.
Therefore, a higher DPO than the industry average would suggest:
Better credit terms than competitors; or
Inability to pay creditors on time
A company with a low DPO may indicate that the company is not fully utilizing its credit period offered by creditors. Alternatively, it is possible that the company only has short-term credit arrangements with its creditors.
Therefore, a lower DPO than the industry average would suggest:
Worse credit terms than competitors; or
Not fully utilizing the credit period offered by creditors.
Example of Days Payable Outstanding
Calculating the DPO with the beginning and end of year balances provided above:
DPO: ($800,000 / $8,500,000) x 365 = 34.35. Therefore, this company takes an average of 34 days to pay back its accounts payable.
The Importance of Days Payable Outstanding
Days payable outstanding is an important efficiency ratio that measures the average number of days it takes a company to pay back suppliers. This metric is used in cash cycle analysis. A high or low DPO (compared to the industry average) affects a company in different ways. For example, a high DPO may cause suppliers to label the company as a “bad client” and impose credit restrictions. On the other hand, a low DPO may indicate that the company is not fully utilizing its cash position and may indicate an inefficiently operating company.
There is no clear-cut number on what constitutes a healthy days payable outstanding, as the DPO varies significantly by industry, competitive positioning of the company, and its bargaining power. For example, Walmart is a huge company in the retail industry. With such a significant market share, the retailer can negotiate deals with suppliers that heavily favor them. As of July 2017, the DPO of Walmart stands at around 42.
Applications in Financial Modeling and Analysis
DPO and the average number of days it takes a company to pay its bills are important concepts in financial modeling. When calculating a company’s free cash flow to the firm (FCFF), changes in net working capital impact cash flow, and, thus, the average number of days they take to pay bills can have an impact on valuation (especially in the short run).