Day Sales Payable is critical part of cash flow management. Here are the details.

 

How to Compute Days Payable Outstanding or More Commonly “DPO” and Improve Cash Flow


Why is Knowing How to Compute DPO Important to my Business?

We have already covered importance of Days Sales Receivables (DSR), Days Inventory On Hand (DIOH), and now the final major operating cash flow metric–Days Payable Outstanding (DPO).  Where DSR and DIOH relate to current assets, DPO pertains to what is typically the largest current liability–Accounts Payable.  Like the other two metrics, business need to understand how to compute DPO and how it impacts cash flow. 

Unlike DSR and DIOH, the higher the number of days of payables outstanding, the better for a business owner.  Though DPO is as important as the other metrics, it seems to be lesser of a focus vs. the other two metrics.  This probably has to do the difficulty in acquiring the data needed to compute DPO.  But that does not make it any less relevant in your cash flow optimization strategy.

Learn more about your Accounts Payable turnover, how to measure and manage it, as well as why it is so important to your cash flow. Click to Tweet

We have already covered importance of Days Sales Receivables (DSR), Days Inventory On Hand (DIOH), and now the final major operating cash flow metric--Days Payables Click to Tweet

How to Compute DPO

Again, just as with DSR and DIOH, the DPO metric is retrospective in that we are looking in the rear-view mirror for context around future actions that will improve cash flow.   The formula for DPO is as follows:

Accounts Payable / Average Daily Disbursements = DPO

For the numerator, you need the month-end balance of your Accounts Payable account.  If your credit cards have balances, add those in as well to current the current accounts payable balance for your business.  Our total Accounts Payable balance should represent the current dollar value of outstanding invoices that a business has taken on credit (or likewise a vendor or bank has extended).  For this example, assume that the month-end April Accounts Payable and outstanding credit card balances totaled $475K. 

Computing the denominator, which is Average Daily Disbursements can be more difficult.  Ideally, what you want to accumulate is all the checks, wire transfers and cash payments the business has made over a given period.  Preferably that period should be 12 months, but can be shorter if you tend to pay your bills very quickly.  Cash payments, or disbursements, include payments for payroll, inventory, credit cards, professional services, etc. 

For our example business, we will assume the following:

  • Past 12 month checks issued = $2,000K
  • Past 12 month wires issued = $1,850K
  • Past 12 month cash payments issued = $50K
  • Total Disbursements = $3,900K
  • Daily Average Disbursements = $3,900K / 365 Days = $10.68K
  • DPO = $475K Accts Payable / $10.68K  = 44 Days Payable Outstanding (DPO)

Note: If you have Debt payments, include those payments in both the numerator and denominator or exclude it from both.

Why is Knowing and Influencing My DPO Metric Important?

As mentioned earlier, the larger the DPO metric the better for your business.  Your ability to increase this metric is directly related to your ability to negotiate favorable terms with your suppliers and vendors.  The more trust your suppliers and vendors have in your business, the more likely they are going to be willing to extend more favorable terms.  The more time your business has to make payments slows the velocity of cash required to sustain your business.  It does not reduce the amount of cash, but it does reduce the velocity. 

In our next post, we discuss the importance of DPO relative to the other cash flow metrics as part of our presentation on the Cash Cycle.  If you are a business owner that is in need of inventory management expertise to help implement your own continuous improvement initiative, please contact us today

 

About the Author
About the Author
Chase Morrison provides CFO services, utilizing Profitwyse’s 3D Growth Platform™, enabling his business owner clients to more readily achieve their goals for wealth creation and family legacy.  Contact him today to learn how your business can hit the accelerator using Profitwyse’s proven platform.

 

Take Action! – Read The Monthly CEO Advisory Report For Tips During These Challenging Times


Profitwyse is a monthly contributor to the The CEO Advisory Report for April 2020, published by Ken Keller with Strategic Advisory Boards.  The Monthly CEO Advisory is a compilation of timely articles from professionals with deep expertise in all areas affecting the privately-held business space.  If you are a chief executive or a C-suite member of a midsize business, The Monthly CEO Advisory contains valuable information take you can put into action today.

Explore The Monthly CEO Advisory for April 2020 to gain insight and solutions into relevant issues affecting business owners today. Click to Tweet

If you would like to be added on regular distribution, please send us a note via our Contact Us page.

What’s in This Edition of The Monthly CEO Advisory For April 2020

CFO Insights | Chase Morrison

Six Eye-Opening Questions You Should Ask Your Controller Today!

Take a look at the Monthly CEO Advisory Report for April 2020 and learn important lessons from the C Suite Click to Tweet

Business Growth & Profits | Ken Keller

Things You Can Do To Better Manage Risk In These Turbulent Times

Commercial Real Estate | Sheryl Mazirow

Learn More About The Kind of Savings And Other Benefits That Can Accrue To You When Utilizing a Tenant Rep

Commercial Insurance | Paul Palkovic

Do We Have Coverage If We Shut Down Our Business Due to COVID-19?

Human Resources Compliance | Barry Cohn

Learn Tips and Tricks For Making Your Employees More Effective

Manufacturing Excellence | BJ Schramm

It’s Time Reconsider Non-Essential Tasks And Focus On the Core Mission

Information Technology | Craig Pollack

5 Tips For Maintaining a Work Life Balance When Working From Home

Company Benefits | Peter Ettinger

Is Your Group Health Plan ERISA Complaint?  Learn What To Look Out For

Alternative Financing | Kristy Melton

The Fed Just Dropped Interest Rates Again!  Learn Why An SBA 7a Loan Might Be Right For Your Business

Sales Management | Paul Mitchell

6 Things To Keep Your Sales Moving Forward During a Time of Crisis — COVID-19

If you have additional questions regarding any of the above segments, please reach out to authors.  Their contact information is included in with the content.

As always, if you need financial management expertise to accelerate growth, improve profitability or enhance cash flow, feel free to contact us today

 

 

How to Improve Inventory Turnover Ratio Using DIOH


Why is Knowing How to Compute DIOH Important to my Business?

Knowing how to improve inventory turnover ratio using DIOH metrics is fundamental skill for all business owners that need to optimize their inventory levels.  DIOH, which stands for Days Inventory On Hand, is a metric for determining how efficiently a product-based business is utilizing a very important current asset–Inventory; consequently knowing how to compute DIOH is important to improving your inventory turnover and to your business.  But more importantly, how you take action using the DIOH metric to balance inventory and service levels are critical to your long-term success as a business owner.  

Knowing how to improve inventory turnover ratio using DIOH metrics is fundamental skill for all business owners that need to optimize their inventory levels. Click to Tweet

Inventory Turnover ratio and DIOH are essentially two sides of the same coin.  As mentioned above, DIOH is the number of days required to exhaust your current stock.

DIOH is meant to reflect the number of days it will take a business to consume the inventory on hand using either historical or forecast demand.  You can compute DIOH metrics for total inventory (raw material, work in process, finished goods), for an individual finished good and for an individual raw material.  The Inventory turnover ratio and DIOH are essentially two sides of the same coin.  This is because you can compute DIOH with the inventory turnover ratio and vice versa.  To compute the inventory turnover ratio using DIOH, just divide 365 days by the DIOH to get the turnover ratio.  For example, if you have a DIOH of 37 days for an inventory item, then your inventory turnover ratio is 12X (365 Days / 37 DIOH = about 12X).  The goal is to pursue either lower DIOH or higher turnover.  Both have the same effect.

Relative to DIOH, the fewer the number of days you can maintain your inventory at, translates into higher positive cash flow.  But your inventory level needs to be balanced with your desired Service Level.  Service Level pertains to the probability you manage to relative to stock outs.  If you set a 95% Service Level, then you are accepting the possibility of stock outs 5% of the time.  More on this later.

How to Compute “Days Inventory On Hand”

Like nearly all accounting metrics, DIOH is retrospective in that you use historical business activity to compute the current monthly metric.  As described briefly above, there are two ways to compute DIOH that are a function of what you are measuring.  If you are attempting to measure an entire company’s DIOH, you would look to the Cost of Goods methodology.  If you are looking at individual inventory items, you would use the Units Consumed methodology.

Computing DIOH Using Cost of Goods

To understand how Cost of Goods is computed, consider what happens when a sales order is fulfilled.  When a sales order is fulfilled, inventory is shipped to an end customer and title of that asset transfers from a vendor (you the business owner) to a customer.  With that title transfer, the cost of all the items shipped is reduced by the standard or average cost of the items shipped.  Or speaking like an accountant, there is a debit to cost of goods and credit to inventory.  I hope your eyes are not already glazing over.  A cost of goods account on a P&L represents the accumulation of costs for all the items shipped to customers.

In order to compute the actual metric you have to have the period ending inventory valuation, which is a summary of the inventory costs for all inventory items a business possesses or holds title to as of the report date.  This will be the numerator in a computation.  The denominator will be the average daily Cost of Goods.  Generally you calculate the average daily cost of goods by using a 12-month rolling total of Cost of Goods and dividing by 365 days. 

Below is an example of the Cost of Goods methodology comparing the inventory efficiency of Walmart vs. Macy’s using their 2020 SEC 10K filings from EDGAR.  Both businesses are in the retail industry, but they have rather dissimilar inventory management capabilities.  Walmart can be considered “Best in Class” especially when you consider the fact that they ended their 2020 fiscal year generating $395B in cost of goods, and did it ending with $44B of inventory on their balance sheet.  In contrast, Macy’s generated $15B of cost of goods, ending their fiscal 2020 with $5B of inventory.  Let’s compare the two:

DIOH Comparison Between Walmart and Macy's with Inventory Turnover

Using Walmart’s SEC filing, we divide their $394,605M by 365 days to $1,081M of average daily cost of goods (if that doesn’t take your breath away…).  Then we divide their 2020 year-ending inventory valuation of $44,435M by the $1,082M average daily cost of goods to get 41.1 days of inventory on hand (DIOH).  Likewise using Macy’s SEC filing, we get a 124.8 DIOH.  We also include their turnover ratios, which are 8.9X and 2.9X, for Walmart and Macy’s, respectively.  

So why is this import–because Cash is King!  Walmart only needs to hold onto 41 days of inventory while Macy’s needs a 125 day cushion.  That is a very “eye popping” distinction.  You also need to think about the turnover, with Walmart at 8.9X and Macy’s at 2.9X.  This means that Walmart is 3 times more efficiently (8.9/2.9 = about 3) turning over their inventory.  Let’s start with the cash issue.  Macy’s has $5.2B of cash securing the inventory they need to run their business.  If Macy’s was able to approach Walmart’s “Best in Class” inventory performance, they could reduce their inventory from $5.2B down to $1.7B (Walmart’s 41.1 DIOH X Macy’s $42M average daily Cost of Goods = $1.7B).  That would free up $3.5B of cash to pay down debt!  How about interest expense?  Assuming Macy’s pay’s, on average 5% on their outstanding debt, that would free up another $1.8B of cash for other purposes.  The reduced inventory, plus reduced interest expense, would increase Macy’s cash flow over $5B.  An event like that would no doubt move Macy’s stock back on to the S&P 500!

Computing DIOH Using Units Shipped/Consumed

When analyze a single inventory item, you want to look at the actual units being shipped for finished goods or consumed for raw materials.  To perform this type of analysis, you will need to develop reports and potentially a data warehouse, where you can retain historical information on shipments and work orders. 

Below is an example of a single finished goods item, that includes some information on the major customers purchasing this items over past 12 months (March 2019 through February 2020), the month-end February 2020 inventory units on hand and the computed DIOH for this one item. 

Excel example showing how to display units shipped in 12 months, units on hand and DIOH as of ME Feb 2020.
The monthly columns for April ’19 to January ’20 are hidden above.

The DIOH is computed in column Z, using the 8,412 units shipped for the most recent rolling 12 months, which comes to shipping on average 23.05 units per day.  Then dividing the month-end February inventory of 5,463 / 23.05 units per day means this business is holding 237 days of inventory as of the report date.

Getting a handle on the DIOH for raw materials is a little more complicated.  Generally, raw materials are consumed on work orders, during the inventory conversion process, and are subsumed into their parent sub assembly or finished good inventory item. 

For example, let’s assume you assemble bicycles and then sell them to bicycle shops.  You need to assemble 15 bicycles of the same model.  Each bicycle requires 1 front wheel.  When you start the work order, you have 100 front wheels in inventory.  Once you confirm the work order, you will have only 85 front wheels in your inventory, assuming your Bills of Material are set up correctly of course, and 15 new assembled bicycles ready for shipment.  In the case of raw materials, you have to get reports that detail how many units are being consumed on work orders to determine the DIOH for each raw material inventory item.  How you do that is beyond the scope of this article, but can be done fairly easily with a data warehouse, where you collect work order confirmation details outside your ERP system.

Gaining Actionable Intelligence Using DIOH

Gaining actionable intelligence using DIOH starts with monitoring trends.  In the Inventory Metrics graphic below you can see that we are measuring the Net Inventory dollars on the left-side Y axis and DIOH on the right-side Y axis.  This graph includes how the business ended both 2018 (200 DIOH), 2019 (208 DIOH) and the currently completed month-end February result of 223 DIOH.  The dashed line reflects improvement over the remainder of the year, trending down to around 190 DIOH by 12/31/20.  Looks like we will need a few initiatives to get there.

Example of inventory metrics with invdentory dollars on the left-side axis and DIOH on the right-side axis.

The actionable intelligence from the above is that inventory is continuing to grow faster than sales.  That’s a problem.  Step #1 is to find an industry benchmark for inventory turns.  Knowing your industry metrics should be an imperative for all business owners to better identify low hanging fruit that can put additional dollars in the bank.

Step #2 is develop more robust inventory reporting to begin reviewing the DSR trends for each finished good item.  In the report below, we have a 6-month DIOH trend for the NM09781 product we discussed above.

DIOH Trending graphic showing 6-month DIOH trend for Part Number NM09781.

Above, you can see the 237 DIOH for month-end February 2020.  In addition to February’s DIOH, you can see the DIOH metrics going back to September 2019, when there was 349 DIOH (or nearly a year’s worth) of inventory on hand.  Every month for the past 6 months, inventory has been trending downward.  This would indicate that our initiatives appear to be working. 

Step #3 is to compute the reorder point (ROP) for this item and work with the Purchasing Department to implement the latest forecast.  The typical ROP is comprised of two components, safety stock and stock consumed during the lead time required to replenish the inventory item (AKA demand over lead time).  Lets run through an example.

How to Compute Reorder Points Using Safety Stock and Demand Over Lead Time

To start our ROP update process, we retrieved the following information from the Purchasing department regarding Item Number NM09781:

Key ROP Parameters for our example Part Number

How to Compute Demand Over Lead Time

First thing to compute is demand over lead time, which is just the amount of stock we plan to ship/sell during the time required from the day a Purchase Order is placed to the day the stock arrives on our dock.  In this example, we have a lead time of 1.00 month combined with a trailing 12-month shipment history of 8,460 units.  The demand over lead time will just be 1/12 of the annual demand or 1/12 X 8,460 Units, which equals 705 Units.  As I said, the demand over lead time is fairly simple.  Now for the safety stock, which is more complicated.

How to Compute Safety Stock

In order to compute the safety stock, we need the following:

  • Service Level % — This is the probability of an item being in our warehouse when an order is scheduled for shipment.  Or 1 minus our Service Level % is equal to the probability of a stock out.  Generally, 95% is a reasonable place to set your Service Level %.  As you increase the Service Level %, the amount of additional inventory required to get 1% higher Service Level begins to get massive.  Conversely, if you want to lower total inventory and are willing to increase your chance of a stock out, then you may want to lower your safety stock to 93%, or whatever.  For our example, we are going with 95%.
  • Lead Time — We already know that our assumed lead time is 1 month.
  • Z Score — Hopefully you had a statistics course or two in college.  A Z Score is the way that we effectuate a statistical estimate of safety stock based on our service level %.  The easiest way to get a Z Score is with Excel.  Just use the following formula which will produce the correct Z Score:  =NORMSINV(SS%).  By using Excel, a 95% service level will produce a 1.645 Z Score.  The lower your service level, the lower the Z Score. 
  • Standard Deviation — We need the standard deviation of demand over some period of time.  Given that we have our lead time and historical demand all summarized by month, we need a monthly standard deviation for our product.  This is fairly simple using Excel, which has a number of methods for computing standard deviations.  Given that we are only going to use 12 months of past shipment history, we are going to use the Student’s T Standard Deviation formula which is: =STDEV.S(Range).  If you have 30+ data points, then use the Population standard deviation formula (=STDEV.P(Range)), which will give a lower safety stock value, reducing the amount of overall inventory required to maintain the same Service Level %.

Here is an example, for the same product we have been discussing, using the 95% Service Level, 1 month Lead Time:

Detail of example of how to compute Reorder points that include demand over lead time plus safety stock.

Though the above is a bit complex, creating a VBA application will make this much easier, which is a service provided by Profitwyse.  The difficult part is establishing a data warehouse were all the information required to compute the analytics can be accessed by a VBA application.  We can help with that too!

One final metric that is helpful for your Purchasing team is to compute a forecast date for the next Purchase Order.  Think of this as the date when the on hand inventory balance reaches the Reorder Point.  In the above example, the information is as of month-end February 2020 (or 2/29/2020). 

Here’s the way to approach an answer to the question when will need to issue the next PO.  Hopefully inquiring minds in the Purchasing Department would like the answer.  As of ME Feb ’20, we have 5,463 units on hand.  The reorder point is 1,275.  Now we just need to determine how many days to get from 5,463–Units on Hand–to 1,275–ROP–the difference being 4,188 units.  Using the information above, we can determine how many days it will take to sell 4,188 units, which is 4,188 / (8,412/365 Days) = 182 days.  Adding 182 days to the ME report date indicates that Purchasing will not need to take action until around August 29, 2020.  Using this report, the Purchasing department can focus on more pressing issues than our example part above.

Final Comments on Days Inventory On Hand

Though we did not mention it above, knowing your industry average DIOH performance or inventory turn over rate is very important relative to providing some objective direction on how aggressively to pursue inventory reduction initiatives.  Regardless, business owners should always take a continuous process improvement philosophy to their inventory improvement initiatives, given that inventory management is a balancing act between maintaining reasonable inventory levels that also achieve service level goals.

If you are a business owner that is in need of inventory management expertise to help implement your own continuous improvement initiative, please contact us today

 

About the Author
About the Author
Chase Morrison  provides CFO services, utilizing Profitwyse’s 3D Growth Platform™, enabling his business owner clients to more readily achieve their goals for wealth creation and family legacy.  Contact him today to learn how your business can hit the accelerator using Profitwyse’s proven platform.