Comparing a company’s DPO year-over-year shows whether its payment cycles to suppliers are shortening or extending. An increasing DPO indicates the company is taking longer to pay suppliers, which preserves working capital but can strain supplier relationships. A decreasing DPO suggests tighter cash flow, as the company pays invoices faster to take advantage of early-payment discounts or avoid penalties.
For example, let’s assume Company A purchases raw material, utilities, and services from its vendors on credit to manufacture a product. 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.
Summary of DPO Formula and Its Applications
If your business is struggling, a high DPO doesn’t indicate good credit and prudent cash management – it means you might not have the money to pay debts on time. You might operate in a niche industry where rapid repayment is expected, so your DPO should be judged on a relative, rather than absolute, basis. Or your suppliers offer early payment discounts, in which case a low DPO means you’re proactively saving money in the long run. Days payable outstanding is one of several key accounts payable KPIs to track and acts as a stand-in for overall operational efficiency. Understanding how the days payable outstanding ratio is an important step in getting a strategic, birds-eye view of your business while opening opportunities for improvement.
By calculating the sum of the accounts payable balance in the current and prior year, and then dividing by two, we arrive at 70 days and 75 days in 2021 and 2022, respectively. Company A has good working capital management because it is paying off its creditors at the end of credit period to avoid default and at the same time shorten its conversion cycle. Most companies also take utilities, rent, storage, and employee wages into consideration. Together these expenses represent the cash flow going out to pay for products your company intends to sell.
The Role of Automation in Accounts Payable Management
As such, companies can optimize (reduce) their CCC by addressing any of these three ratios – in other words, by increasing DPO or by reducing DSO or DIO. On the other hand, a business with a high DPO may want to consider adjusting its payment frequency by taking advantage of favorable terms. Company A days payable outstanding formula is interested in calculating its DPO for 2022 using its average AP balance for the year. For example, if you’re calculating DPO for the quarter, the number of days would be 90. These costs are considered the cost of sales or cost of goods sold or COGS and are necessary to create the finished product.
A low DPO, on the other hand, can indicate inefficiencies in the payment process, poor cash flow management, and potential liquidity issues. Days payable outstanding is an important efficiency ratio that measures the average number of days it takes a company to pay back suppliers. 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.