DPO indicates how many days the company takes to pay the money back to its supplier. In other words, it measures the average time cycle for payments to suppliers/creditors in days.
Days Payable Outstanding = ( Average Payable / Cost of Goods Sold ) * 365
The average accounts payable of company ABC is Rs 100 and the cost of sales is Rs 1000. Then the DPO is 36.5 days.
It takes 36.5 days for the company ABC to pay back money to its suppliers.
How to use it Practically
A higher DPO of the company than the industry average would suggest two things, First – better credit terms than its competitor, and second – inability to pay creditor/supplier on time.
If the company is in the first category, then it indicates the competitive strength of the company but if the company is in the second category then it indicates upcoming financial trouble for the company.
An investor should avoid companies of the second type. One of the ways to differentiate the two companies is to see the liquidity ratio. If the company has a high liquidity ratio then it belongs to the first category or else it belongs to the second category.
A high DPO is generally advantageous for a company. If a company takes longer to pay its creditors, the excess cash on hand could be used for short-term investing activities.
A company with a low DPO may indicate that the company is not fully utilizing its credit period offered by suppliers/creditors or worse credit terms than its competitor. In both of the cases, it indicates the management’s inability to build a strong competitive strength around the working capital management is clearly visible.
There is no benchmark number on what constitutes a healthy day payable outstanding, as the DPO varies significantly by industry. Normally, look for companies with high payables days along with high liquidity ratio (or cash ratio) which are the best candidate for investment