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