|DPO = Number of Days x
|Average Accounts Payable
The formula can easily be changed for periods other than one year or 365 days. For instance, you can set the number of days for a month (30 days) or quarter (91 or 92 days). That means that the average accounts payable (A/P) and cost of goods sold (COGS) should also be measured over the same period.
Accounting software like QuickBooks Online can quickly generate the reports you need to calculate DPO. If you’re still using Microsoft Word or Excel for your bookkeeping, we recommend you upgrade to QuickBooks. Sign up today and qualify for up to 50% off on a paid subscription.
Understanding Days Payable Outstanding
As one of the useful financial ratios, analyzing days payable outstanding provides insights into your business’ cash and A/P management practices. Here are some ways you can use the DPO for business analysis:
- Benchmark industry standards: It is best practice to compare DPO with industry averages to determine if your business is still within the normal levels. While analyzing your business’ DPO provides a lot of insights, comparing it with industry averages reveals the bigger picture. For instance, it might be normal for your industry to have low DPOs.
- Indicate poor cash management: When DPO is high, the business takes too long to pay its suppliers. This scenario would translate to cash shortages due to declining sales or poor collection of customer invoices. On the contrary, low DPOs might indicate paying vendors too soon and burning excess cash that could’ve been reinvested in the business or used to pay for other liabilities that are nearing the due dates. Paying too soon also means that the business may not be utilizing credit periods granted by suppliers assuming there is no early payment discount.
- Identify possible poor relationships with suppliers: It’s possible that low DPOs may imply poor relationships with suppliers since the business can’t access a longer credit period because the business has a history of missing payments. If your business always pays late, suppliers will not grant longer credit periods to you.
- Purchase short-term investments: On a positive note, a high DPO may indicate the existence of short-term investments. Wise business owners use excess cash to purchase short-term investments to generate more revenue streams for the business. Hence, it may take longer for the business to pay suppliers.
Days Payable Outstanding Example
In manually computing days payable outstanding, you need your balance sheet for the end of the current and prior year and a total purchases report. You can use these documents to identify inventory purchased and to calculate COGS and average A/P.
Sum all purchases of inventory—whether paid with cash or credit—for the period. If you use QuickBooks Online, you can run a vendor purchases report and select only the suppliers from which you buy inventory. Exclude payments for non inventory items, such as rent and utilities. Check out our list of the best small business accounting software to explore more solutions.
COGS is the cost of merchandise sold during the year.
Step 2.1: Calculate the goods available for sale during the year by adding purchases to beginning inventory, which is the same as ending inventory from the prior year.
Beginning Inventory + Purchases = Goods Available for Sale
Step 2.2: Subtract ending inventory from goods available for sale to arrive at COGS.
Goods Available for Sale – Ending Inventory = Cost of Goods Sold
For example, Joe’s Sprocket Supplies had the following inventory and purchases:
Inventory as of Dec. 31, 2021
Inventory as of Dec. 31, 2022
Inventory Purchased during 2022
The goods available for sale and COGS during 2022 are:
Inventory purchased during 2022
Goods available for sale
LESS: Ending inventory
Cost of goods sold
If your accounting software has good inventory accounting, like QuickBooks Online, you can avoid manually calculating COGS by running a Profit and Loss report, which will show you the COGS for the period.
Average A/P is the amount owed to suppliers during the year. Only include suppliers from which you purchased inventory when calculating DPO―for example, exclude payables to a utility company.
The most common method of calculating the average is to add the beginning and ending A/P and divide by 2:
|Average Accounts Payable
|Beginning Accounts Payable + Ending Accounts Payable
Assume Joe’s Sprocket Supplies had the following A/P:
Accounts payable as of Dec. 31, 2021
Accounts payable as of Dec. 31, 2022
The average A/P is calculated as:
($6,000 + $10,000) ÷ 2 = $8,000
Once you have calculated average A/P and COGS, you’re ready to calculate DPO―divide average A/P by annual COGS, then multiply by 365 days.
For example, Joe’s Sprocket Supplies’ average A/P is $8,000 and annual COGS is $95,000. Its DPO is 30.7 days (365 X $8,000 ÷ $95,000 = 30.7).
Tips on Improving DPO
Improving your DPO gives your business a positive image to vendors and creditors. Here are some tips that might help you:
- Improve the A/P process to reduce processing time and complexity in paying vendor bills
- Avoid paying beyond the due date to build a good credit history
- If the vendor doesn’t offer early payment discounts, maximize the credit period and pay two to three days before the due date
- Improve collection of customer receivables to recover cash tied to receivables
- Utilize lines of credit and use cash only for purchases when necessary
- Negotiate longer credit terms with suppliers
Frequently Asked Questions (FAQs)
Theoretically, a DPO close to your typical payment terms is generally best. If your vendors typically give you 30 days to pay, then your DPO should be just under 30 days. However, another useful measure is to compare your DPO with industry averages.
DPO can be used to determine how long it usually takes for you to pay suppliers. For instance, a DPO of 40 days might not work for a supplier who only gives credit terms of 30 days.
Days payable outstanding reports how many days it takes to pay suppliers. Too low a value indicates you may be paying suppliers sooner than necessary, whereas too high a value indicates you may have cash flow problems. The optimal value should be slightly less than the standard payment terms given by your suppliers.