How to Use Days Payable Outstanding to Analyze a Company's Finances
Days Payable Outstanding is a powerful, often overlooked financial analysis metric. It can be especially useful in evaluating companies you're thinking of investing in. But what is this metric and how can it help you?
Understanding the Days Payable Outstanding (DPO) metric
What does Days Payable Outstanding mean?
Days Payable Outstanding (DPO) is a metric that can be used to analyse a companies financial health. Simply put, it's the number of days a company takes to pay its suppliers. It's also knows as trade payables days or accounts payable days.
A low DPO usually indicates an efficient and effective company while a high DPO may indicate a company is facing cash flow problems. In this post we'll explore the use of DPO as a financial analysis tool using a car retailer example.
The DPO ratio is an important indicator of the liquidity position of a company. It helps you identify potential issues with cash management and working capital management.
How do you calculate days payable outstanding?
Days Payable Outstanding (DPO) is a liquidity ratio that measures a companies ability to meet its short-term obligations. You can calculate DPO by dividing total accounts payable (or payables) by average accounts receivable (or sales). For example:
Total Accounts Payable / Average Accounts Receivable = Days Payable Outstanding
This gives you an estimate of how many days it takes to pay off all your bills — if every invoice was paid today, this would be how long you'd have to wait before having no bills left outstanding.
If a company has more than 100 days of payables outstanding, it indicates that there might be an issue with cash flow. On the other hand, if the company has less than 90 days, then it should have no problem paying off its bills in time.
Keep in mind that the DPO does not take into account seasonality, which is a crucial parameter in many business sectors (tourism, trade, etc.).
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Using DPO to determine whether a company has financial leverage
Days Payable Outstanding (DPO) is one of the most popular metrics used to determine the financial leverage of a company. It shows how long the company can continue operations without having to borrow money from a bank or other external source. As such, it's a great tool for analyzing a company's finances.
Is it better to have a high or low days payable outstanding?
The lower the number, the better it is for investors, since it means that the company has an ample amount of cash on hand and can pay its bills within a short period of time. A high DPO indicates that the company is likely to have trouble paying its bills in the near future.
A high DPO can indicate that a company has financial leverage and will likely need to raise more capital through either debt or equity financing in order to keep operating at its current level. However, there are many other factors that affect DPO, which means that this information should be taken with some skepticism when analyzing a company's financials.
The higher your DPO, the longer it takes your company to pay its suppliers. An unpleasant observation, as it can reveal :
- Flaws or malfunctions in the customer management system;
- Financial difficulties, which represent a risk from the suppliers' point of view;
- For your suppliers, a feeling of not being considered a priority.
Using DPO in an Accounts Payable Analysis
Days payable outstanding (DPO) is a great financial ratio to use in an Accounts Payable analysis. It measures how many days of sales (payable days) are being financed by accounts payable. The higher the number, the more likely it is that the company is having trouble paying its bills on time.
Together with the Day Sales Outsanding (DSO, aka Days Receivable Outstanding), this is one of the main areas for steering the customer management item.
- The DPO indicates the time it takes your company to pay its supplier invoices.
- The DSO indicates the risk of non-recovery of a customer account.
DSO and DPO in financial analysis
Payable and receivable days analysis can produce two possible scenarios:
- DPO is higher than DSO: the company takes longer to pay its supplier invoices than to collect its customer receivables.
- DSO is higher than DPO: the company pays its suppliers before being paid by its customers. In other words, it advances its payments on a turnover that has been invoiced but not collected.
A cash flow mismatch, which may ultimately put the company in debt. Purchasing and payment departments can then consider increasing the DSO. By doing so, they reduce the companies working capital requirement (WCR) and improve its cash flow.
Using DPO to compare companies in different industries
The first thing you should know is that optimizing your DPO does not necessarily mean reducing it. On the contrary, a company with a long DSO will seek to extend its DPO to avoid the risk of debt.
The DPO is assessed in comparison with the DSO, but also taking into account the average payment period in the companies sector of activity. In order to make the best use of its cash flow, the company will try to base its DPO on the average DPO in the industry.
The company can then adjust its sales policy according to whether the days payable outstanding is below or above the industry average:
- DPO is below the industry average: the company may consider increasing the number of days of late payment.
- DPO is above average: the company can consider reducing its payment delays, for example by installing cash management software.
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What is a good days payable outstanding?
A good days payable outstanding is usually considered to be less than 90 days, although there are exceptions. If your company has a DPO of less than 90 days, it means that you sell your product and get paid quickly. It also means that you're able to pay your suppliers on time and they'll want to work with you in the future.
How do you calculate DPO and DSO?
To calculate DPO, you first need to know how much money you've owed your suppliers and vendors. You then subtract that figure from your total revenue for the period. The remaining number is your Days Payable Outstanding.
In order to calculate DSO, you first need to know how much money you've owed your suppliers and vendors. You then subtract that figure from your total revenue for the period. The remaining number is your Days Sales Outstanding.
How to improve days sales outstanding?
Here are some ways you can improve DSO:
- Improve credit policies and procedures
- Encourage customers to pay more quickly by automating your payment reminders and collection plans.
- Use a customer retention plan that rewards customers who pay on time with better discounts and offers exclusive perks for those who pay early in the year.