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How to calculate days payable outstanding & optimize cashflow

4 Nov

,

2024

Indian guy reading about Day payable outstanding

Juggling suppliers, cashflow, and growth can be challenging for SMB owners. That’s where Days Payable Outstanding (DPO) comes in, as it’s a critical metric that provides insights into financial health and helps optimize funds. 

Understanding it is essential for balancing timely bill payments with maintaining cashflow for growth opportunities.

By optimizing this metric, you can extend the time to pay suppliers, freeing up cash for other critical needs.

However, an imbalanced number can harm supplier relationships or result in missed early payment discounts.

This article will guide you on how to figure out DPO, including the calculation formula and how it reflects your business payment practices. 

Also, it will tell you why you need to benchmark your numbers against industry standards. 

Ready to master DPO and transform your business’s financial health?

What is Days Payable Outstanding (DPO)?

Days Payable Outstanding is a key financial metric that measures the average number of days a business takes to pay its suppliers and vendors for goods and services received.

This ratio is crucial to understand how efficiently a company manages its cashflow and accounts payable process.

A higher DPO generally means the company takes longer to pay its bills, allowing it to retain cash.

This can be advantageous as it provides additional time for investment or managing other financial obligations

However, an excessively high DPO might signal potential finances problems or strained supplier relationships.

But how does it work? Let’s say Taylors Co.,  a small manufacturing business, has a 45 days DPO.

This means Taylors Co. takes an average of 45 days to pay suppliers.

By effectively managing this metric, the SMB can optimize its cashflow, ensuring it has sufficient liquidity to cover other expenses or invest in new projects.

Conversely, if the DPO becomes excessively high, it might indicate that the business is struggling to meet its financial commitments on time, which could harm its reputation and supplier relationships.

Is there a difference between DPO and DSO?

Both are critical financial metrics that provide insights into a company’s cashflow management, but they measure different aspects.

While DPO measures how long it takes to pay suppliers, Days Sales Outstanding (DSO) measures how quickly your company collects payments from customers. In other words, it reflects the effectiveness of your accounts receivable process. 

A high DSO can indicate slow collections, potentially straining resources. Conversely, a low one suggests that customers are paying quickly, enhancing cashflow.

For example, let’s consider ABC Retail:

  • If the business has a DPO of 50 days, it means it takes, on average, 50 days to pay its suppliers.
  • If its DSO is 30 days, it means it takes 30 days to collect payments from customers.

Efficiently managing both metrics ensures that ABC Retail maintains healthy finances, as 68% of SMBs in the US, according to a US Chamber report, balance the time it takes to pay suppliers and to collect from customers.

However, if the DSO were to increase significantly, it could indicate that the retail business is facing delays in receiving payments, potentially leading to cashflow challenges. 

DPO and DSO are key components of the Cash Conversion Cycle (CCC), which tracks how long it takes for a company to convert its investments in inventory and other resources into cash. 

The relationship between DSO and DPO can indicate the balance between inflows and outflows of cash.

Ideally, you want a short CCC, meaning you collect payments quickly and delay outflows without jeopardizing supplier relationships.

Securing the capital you need to scale your business can be challenging. Learn 5 tips for raising funds and prevent assets problems. 

Why is DPO important for your business?

This ratio is a vital metric that directly influences your company’s liquidity and overall financial health.

By extending payment terms to suppliers, you can preserve cash for investments or operational needs.

However, excessive delays can harm supplier relationships and lead to missed discounts.

Conversely, paying suppliers promptly can strengthen relationships and potentially secure better terms, but it may reduce working capital.

Finding the right balance between managing breads and maintaining strong supplier relationships is essential —understanding your DPO is key to achieving this.

We'll provide a step-by-step guide to calculating DPO in the next section to help you optimize this key financial metric.

DPO formula: how to calculate it?

To calculate Days Payable Outstanding, you'll need three key figures:

  1. Accounts Payable (AP): the total amount your business owes to suppliers at the end of a period.
  2. Cost of Goods Sold (COGS): the direct costs of producing the goods your business sells.
  3. Number of days: the length of the period you're examining (typically 365 days for a year).

The formula for DPO is: 

Days payable outstanding formula [infographic]

Step-by-step guide to apply it:

  1. Gather data: start by determining your total Accounts Payable at the end of the period and your COGS during the same period.
  2. Apply the formula: multiply your Accounts Payable by the number of days in the period (e.g., 365 for a year).
  3. Divide by COGS: take the result from step 2 and divide it by your COGS. The final number represents the average days it takes your company to pay its suppliers.

Here's an example: 

Let's say your company has an Accounts Payable balance of $200,000, a COGS of $1,000,000, and you're analyzing over a year (365 days).

Your DPO would be:

DPO = (200.000 x 365 / 1.000.000) = 73 days

This means it takes your business an average of 73 days to pay its suppliers.

Is it better to have a high or low Days Payable Outstanding?

The ideal Days Payable Outstanding depends on your business needs and industry benchmarks, with no universal standard.

However, understanding the advantages and disadvantages of both high and low DPO can help clarify their impact.

High DPO

Pros:

  • Enhanced cashflow: retains cash longer, improving liquidity for reinvestment or operational needs.
  • Stronger negotiation leverage: suggests effective supplier negotiation, potentially leading to more favorable credit terms.

Cons:

  • Potential financial stress signal: an excessively high DPO can indicate cashflow issues, possibly damaging supplier trust.
  • Tighter payment conditions: suppliers may respond with stricter terms if they perceive payment delays as a risk.

Low DPO

Pros:

  • Improved supplier relations: prompt payments can strengthen supplier relationships, potentially leading to better terms or early payment discounts.
  • Financial incentives: captures early payment discounts, offering cost savings through timely payments.

Cons:

  • Reduced liquidity: depletes available cash, which may limit financial flexibility.
  • Missed cashflow optimization: sacrifices the opportunity to optimize cashflow by extending payment terms.

Speaking of improving your relationship with your supplier, learn more about how to strengthen it with effective strategies, especially for international trade. 

Days Payable Outstanding FAQs

What is Days Payable Outstanding (DPO)?

It’s a financial metric that measures the average number of days it takes a company to pay its suppliers for goods and services received. It's a key indicator of cashflow management and supplier relationships.

What is the difference between DPO and DSO?

DPO focuses on how long a company takes to pay its suppliers, while DSO measures how quickly a company collects payments from its customers. Both are crucial for cashflow management.

Why is DPO important for my business?

The ratio affects your cashflow, supplier relationships, and overall financial health. By managing this number effectively, you can optimize cashflow, improve supplier relationships, and potentially negotiate better terms.

Is it better to have a high or low DPO?

The ideal metric depends on your industry and business goals. A high DPO can improve cashflow but may strain supplier relationships. A low one can strengthen supplier relationships but may limit cashflow. The key is finding the right balance.

How can I improve my levels without harming supplier relationships?

You can improve Days Payable Outstanding by negotiating longer payment terms with suppliers, optimizing your procurement process to reduce purchase order lead times, and implementing early payment discount programs. It's essential to maintain open communication with suppliers and avoid excessive delays.

How does DPO relate to other financial metrics?

The metric is closely linked to the Cash Conversion Cycle (CCC), which measures the time it takes to convert inventory into cash. A lower number contributes to a shorter CCC, improving overall cashflow efficiency.

Elevate your cashflow and make DPO work for you

Mastering and optimizing your Days Payable Outstanding is essential for maintaining a healthy cashflow and fostering strong supplier relationships. But what if you could take your financial strategy even further? 

With Stenn's revenue-based financing options, you can seamlessly bridge cashflow gaps and accelerate your business growth. Don’t let payment terms limit your potential. 

Talk to our team, discover our flexible financing solutions today and unlock the full potential of your business!

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