Cash Flow Strategy: Increase Days Payable Outstanding
When I was a kid, I loved to page through the toy catalogs that came in the mail at Christmastime. I made a list of every toy I wanted from Santa. Likewise, small business owners have long wish lists of items that would make life easier and the business more prosperous. Having cash on hand to turn wishes into reality requires a steady, strong cash flow. One way to improve cash flow is to increase Days Payable Outstanding. Days Payable Outstanding, commonly abbreviated as DPO, is a financial ratio that shows the average days it takes for a company to pay invoices from vendors, suppliers, or creditors. DPO typically is calculated on an annual or quarterly basis, showing how a company manages the outflow of cash.
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How to Calculate Days Payable Outstanding (DPO)
To understand Days Payable Outstanding, you need to know how to calculate it:
DPO = Accounts Payable × Number of Days / Cost of Goods Sold
For example, let’s say that XYZ Company has $49.1 million in accounts payable and $420.1 million in cost of goods sold. Here’s the math to calculate the annual DPO: (49.1 * 365) / 420.1 = 42.7 days. This means the company paid back its suppliers after about 43 days. (To calculate DPO per quarter, change 365 to 90.) A DPO of 43 days means XYZ Company held onto its cash for over a month. If XYZ decreases its Days Sales Outstanding (I wrote about this financial strategy, Click Here) while increasing DPO, it improves its cash reserves and liquidity.
How a High DPO Relates to Cash Flow
High DPO indicates that a company takes longer to pay its bills. Generally, a high DPO is advantageous for an organization. If a business holds onto its cash longer, then it has more cash on hand for short-term investments. Additionally, with more working capital on hand, a business has the cash flow to implement business strategies that might otherwise be out of reach (refer to wish list above). However, a high DPO isn’t always a positive sign. Sometimes, high DPO indicates a cash flow emergency! A company struggling to pay its bills on time jeopardizes its relationship with suppliers and creditors. Consequently, suppliers and creditors may tighten their credit terms or refuse to extend credit altogether. In this situation, high DPO means a company is in a pinch financially.
How Payment Terms Affect DPO
An ideal DPO varies by industry and the size of the company. Because big companies have more bargaining power, they typically can negotiate better payment terms than small businesses. However, even the smallest companies can negotiate with suppliers and financiers Click Here to agree upon better terms than a default offer. Longer payment terms allow businesses to increase DPO. But extended payment terms need to be compared with early payment discounts. Are these discounts more advantageous than extended payment terms? Do the math and find out.
How to Improve Cash Flow for Small Business
Prosperity offers a free report, 105 Ways to Improve Cash Flow in Your Small Business, Click Here and a video Click Here explaining what cash flow means for a small business. Prosperity Bookkeeping has proven systems that help small businesses put their money to work for them. Contact us for fully integrated accounting processes, bookkeeping, and consultation services.