What it means
Trade credit is the largest source of short-term finance for most businesses, and days payable outstanding measures how much of it a business uses. When a supplier delivers goods and is paid forty days later, it has lent the buyer the value of those goods, interest-free, for forty days.
For a business buying $75,000,000 a year, each day of payables is worth about $205,000 of cash, so moving from 40 to 60 days would release about $4,000,000, which is why large companies negotiate hard on payment terms. The calculation divides average accounts payable, usually the mean of opening and closing balances, by the purchases the payables relate to, and multiplies by 365.
Cost of goods sold is the common denominator because it comes from the income statement, but it differs from purchases by the change in inventory, so purchases is the more accurate base where it is known. Payables should include only trade payables for goods and services, not accruals, tax or other liabilities, and services charged to operating expenses should be included in both numerator and denominator.
Interpreting the figure means comparing it with the payment terms the business has agreed. A company on 30-day terms with payables of 45 days is paying late, which may reflect deliberate stretching, poor processes or disputes that suppliers will notice, while a company on 60-day terms paying at 45 is paying early and giving away cash.
Industry patterns vary, with supermarkets and large manufacturers running 60 to 90 days, small businesses with little leverage often paying in 30 or less, and construction having its own retention and stage payment practices. Stretching payables is the cheapest source of cash a company has, and also the most easily abused.
Suppliers who are paid late price the delay into their next quotation, put the customer on lower priority when supply is short, insist on deposits or, in extreme cases, stop supplying, and small suppliers may be pushed into difficulty, which brings reputational damage and, in some countries, regulatory attention because several jurisdictions require large companies to report payment practices and penalise late payment. The sustainable approaches are negotiated rather than imposed: longer standard terms agreed at contract time, early payment discounts that let suppliers choose, and supply chain finance programmes in which a bank pays suppliers early at the buyer's credit rating while the buyer pays the bank later.
The other side of payables management is discounts. A supplier offering 2% for payment within 10 days on 30-day terms is offering a very high implied annual return for paying twenty days early, well above any borrowing cost, so a company that stretches payables and forgoes such discounts is borrowing from its suppliers at a rate it would never accept from a bank.
Good payables management takes every worthwhile discount, pays everyone else on the agreed date and not before, and negotiates the terms rather than breaching them.
In practice
Real-world examples
Example 1
A supermarket group buys $5,000,000,000 of goods a year and pays on average at 55 days, holding about $750,000,000 of supplier credit. That credit finances a large part of its stores and stock.
Example 2
A small engineering firm buys $6,000,000 of materials a year and pays every supplier by return because the owner dislikes owing money. Its days payable outstanding of 12 against 30-day terms means it is lending its suppliers about $300,000 (18 days x $6,000,000 / 365) that it could use itself.
Example 3
A retailer with days payable outstanding of 95 against 60-day terms is put on stop by three key suppliers before Christmas and loses sales worth far more than the interest it saved.
Think of it
DPO is like how long you wait to pay your credit card bill-longer preserves cash but may have consequences.
Formula
Calculation
Days payable outstanding = Average accounts payable / Cost of goods sold x 365
More precise: Days payable outstanding = Average accounts payable / Purchases x 365
Purchases = Cost of goods sold + Closing inventory minus Opening inventory
Payables at a target = Target days / 365 x Purchases
Annualised cost of forgoing a discount = Discount % / (100% minus Discount %) x 365 / (Full term days minus Discount period days)
Worked example. A manufacturer had trade payables of $7,500,000 at the start of the year and $8,500,000 at the end. Cost of goods sold was $73,000,000 and inventory rose by $2,000,000, so purchases were $75,000,000.
- Average payables = ($7,500,000 + $8,500,000) / 2 = $8,000,000
- Days payable outstanding on cost of goods sold = $8,000,000 / $73,000,000 x 365 = 40.0 days
- Days payable outstanding on purchases = $8,000,000 / $75,000,000 x 365 = 38.9 days
- The company's standard supplier terms are 45 days, so it is paying about a week early
Paying on terms. Payables at 45 days = 45 / 365 x $75,000,000 = about $9,250,000, releasing about $1,250,000 of cash simply by paying on the agreed date rather than before it.
Discounts. $20,000,000 of the purchases come from suppliers offering 2% for payment within 10 days on 30-day terms. Taking the discount saves $400,000 a year. Forgoing it to pay on day 30 costs 2 / 98 x 365 / 20 = 37.2% a year, so the discount should be taken even if the company borrows at 8% to do so.
Supply chain finance. The company's bank offers a programme under which suppliers can be paid on day 10 at an annual rate of 4% while the company pays the bank on day 60. A supplier of $20,000,000 a year who takes early payment pays about 4% x 50 / 365 = 0.55% ($110,000 a year) for the certainty and speed. If all suppliers moved to 60-day settlement, the company's payables would rise to 60 / 365 x $75,000,000 = about $12,300,000, releasing about $4,300,000 of cash compared with the current $8,000,000, with suppliers paid sooner than before rather than later.Case study
Seen in the real world
This is a fictional, illustrative scenario. A retail chain with annual purchases of $200,000,000 paid its suppliers on average at 45 days, holding about $24,700,000 of payables. A new finance director, under pressure to reduce borrowings, wrote to all suppliers announcing that standard terms were now 90 days with immediate effect. On paper the change would double payables to about $49,300,000 and release about $24,600,000 of cash, saving about $1,230,000 a year in interest at 5%. The suppliers' response arrived over the following six months.
The larger ones repriced: the next round of cost prices rose by an average of 3%, which on $200,000,000 of purchases was $6,000,000 a year, nearly five times the interest saved. Two of the smaller suppliers, unable to fund 90 days of the retailer's stock, went into administration, and their lines had to be re-sourced at higher cost and with gaps on the shelves. Several suppliers moved the retailer to the back of the queue for allocations of popular products. A trade body complaint led to press coverage of the retailer's treatment of small suppliers. The board reversed the policy within the year.
The replacement approach was negotiated. Standard terms were reset at 60 days, agreed supplier by supplier as contracts renewed, with cost prices held. A supply chain finance programme was put in place so that any supplier could be paid at day 10 at a cost linked to the retailer's credit rating, which for the small suppliers was cheaper than their own overdrafts. Payables settled at about $32,900,000 (60 days), a release of about $8,200,000 against the original position, and supplier relationships recovered. The finance director's successor observed that the first approach had treated suppliers as a source of free money, and that there is no such thing.
Watch out
Common mistakes
- Using cost of goods sold as the denominator when inventory is changing significantly, which misstates the days; purchases is the accurate base.
- Treating a rising days payable outstanding as good without checking whether it reflects negotiated terms or simply late payment, which suppliers will price into future quotations.
- Stretching payables while forgoing early payment discounts, which is borrowing from suppliers at an implied annual rate that can exceed 30%.
Questions
People also ask
Is a high days payable outstanding good or bad?
It is good when it reflects negotiated terms and strong buying power, since it provides interest-free finance. It is bad when it reflects late payment, because suppliers respond with higher prices, lower priority and, eventually, refusal to supply.
How does it fit into the cash conversion cycle?
The cycle is inventory days plus receivable days minus payable days. A longer payable period shortens the cycle, meaning the business's cash is tied up for less time between paying suppliers and collecting from customers.
What is supply chain finance?
A bank arrangement under which suppliers can choose to be paid early, at a discount based on the buyer's credit rating, while the buyer pays the bank on the full term. It extends the buyer's payable days while shortening the supplier's receivable days, which is why both sides use it.