The information presented in a company’s financial statements can provide significant insights into its operations. For stakeholders, particularly shareholders and investors, this information can be significantly crucial. Of these financial statements, most stakeholders focus on the balance sheet, income statement, and cash flow statement. Sometimes, however, the information presented in these statements may not be sufficient.
In those cases, stakeholders will need additional information on which they can base their decisions. In most circumstances, obtaining internal information can be challenging since companies don’t disclose them. However, they can still use other techniques to enhance the quality of the data presented in the financial statements. This process falls under the calculating and interpreting of financial ratios.
Financial ratios are crucial metrics that calculate the relative magnitude of one figure to another. In most cases, these ratios consider how one item in the financial statements differs from another. Through this process, stakeholders can reveal information that companies do not disclose directly. On top of that, these metrics are available for everyone, making them significantly more beneficial.
What are Activity Ratios?
Activity ratios are a type of financial ratio that provides valuable insights into a company’s operations. These ratios allow stakeholders to determine the efficiency with which a company uses its assets to generate sales. In other words, activity ratios look at how companies make sales through the use of their resources. This way, stakeholders can establish whether the company utilizes its assets to a full extent.
Activity ratios usually include one metric for most calculations, a company’s revenues or sales. This figure becomes the numerator for the calculations. On the other hand, these ratios also consider assets or other resources as the numerator. This way, they determine the relative ratio between the sales made and the relative resources used.
However, activity ratios don’t consider the efficiency with which companies generate money only. They can also explore other areas. In particular, activity ratios also look at how companies manage their resources and obligations. Therefore, they also consider the company’s working capital management. For this, it uses several ratios to determine how efficiently the company generates cash.
Overall, activity ratios can be highly crucial in understanding how a company uses its resources. More importantly, these ratios consider the efficiency in the use of assets and liabilities to continue operations. Several activity ratios are prevalent among stakeholders, including the various turnover ratios. However, stakeholders may also consider days outstanding ratios, including the days payable outstanding.
What is Days Payable Outstanding?
Days payable outstanding (DPO) is a financial ratio that measures the average time for a company to pay its bills. In particular, this ratio looks at how long a company keeps its cash resources before using them to compensate suppliers. This ratio helps stakeholders look at how effectively a company manages its cash resources. More specifically, it establishes the use of better credit policies from suppliers.
Days payable outstanding presents the number of days or months a company needs to pay bills. Usually, the higher this ratio is, the better stakeholders will consider it. However, too high of a term can also indicate issues with payments. More specifically, it can signal stakeholders about cash management issues which lead to slower reimbursements to suppliers.
Most companies make it a policy to retain cash resources as long as possible. Usually, the highest outflow that occurs for companies is the payment of bills to suppliers. Therefore, it is ideal for companies to delay those payments for as long as possible. This way, they can retain their cash resources for longer and generate income on them.
In practice, however, companies have to consider several factors to determine when the optimal payment time should be. Usually, the credit term decided with the supplier plays a crucial role in this process. On top of that, companies may also pay suppliers earlier to avail cash discounts. Some other factors may also contribute to the decision to repay suppliers.
Overall, days payable outstanding helps stakeholders understand a company’s payment policy better. This activity ratio can indicate how well a company manages its cash outflows. The result from this ratio usually differs depending on the base used for it. Usually, stakeholders prefer to look at this ratio in terms of days. Some others may also calculate it in months or quarters.
How to calculate Days Payable Outstanding?
Days payable outstanding shows the average time it takes for companies to repay suppliers for invoices. As mentioned, stakeholders can calculate this ratio using different bases. As the name implies, most investors prefer for this ratio to be in days. However, some may also change the period to months or weeks. Overall, the formula for days payable outstanding is as below.
Days Payable Outstanding (DPO) = (Average accounts payable / Cost of goods sold) x Number of days in an accounting period
Alternatively, stakeholders can also use the following day’s payable outstanding formula.
Days Payable Outstanding (DPO) = Average accounts payable / (Cost of sales / Number of days in accounting period)
Both methods of calculating days payable outstanding result in the same result. Nonetheless, these help stakeholders measure the ratio for companies based on the information available. On top of that, these formulas for days payable outstanding allow companies to calculate the average time for repayment. This way, they can understand how to improve the days payable outstanding.
What Are the Five Tips to Improve Days Payable Outstanding?
Through the above calculation, it is possible to understand the factors that impact the ratio. Usually, companies can choose from various options to manage and improve this ratio. However, all of these options may not be available at the time. For most companies, the process may differ based on their processes and suppliers.
Nonetheless, given below are the top five tips to improve days payable outstanding.
The most obvious answer to improving days payable outstanding is to delay payments. Once companies do so, the accounts payable balance will increase. Consequently, the numerator for the ratio will also be higher. This way, the average number of days resulting from the calculation will increase. Therefore, delaying payments is crucial to improving days payable outstanding. However, suppliers may not allow it.
Better terms from suppliers
Companies can also improve days payable outstanding by getting better terms from suppliers. This way, they will have more time before repaying those suppliers for their goods and services. The longer it takes to repay their suppliers, the more balance will accumulate in the accounts payable. Therefore, the days payable outstanding will improve.
If the primary objective for companies is to improve the days payable outstanding, they can focus on timing repayments. This way, they must only make payments after the end of an accounting period. Through this process, the average accounts payable balance will increase. Consequently, it will improve days payable outstanding.
Companies can also improve days payable outstanding by automating payments. Through this process, they can determine the optimal time to repay suppliers. Usually, the longer it takes for the software to reimburse the supplier, the better it will be for days payable outstanding. However, the automation process must also consider the terms offered by suppliers.
Reduce the cost of sales
Another method of improving days payable outstanding is to reduce the cost of sales. This process will lead to a decreased denominator for the calculation. As a result, the days payable outstanding will increase. However, this process may not be as straightforward. Some companies can also increase their closing inventory to achieve it.
Days payable outstanding is an activity ratio that shows the average time it takes companies to repay suppliers. This ratio helps establish the efficiency with which companies settle their payable balances. Usually, the higher it is, the more stakeholders will prefer it. There are several methods to improve days payable outstanding, some of which are available above.