How Far Can We Go in Extending Supplier Payment Terms? Days Payables Outstanding (DPO) in S&OP/ IBP

Feb 3, 2024 | S&OP/ IBP

What are the average payment terms to your suppliers? 60, 90, 120+ days? Supplier payment terms have a significant impact on a cash metric that is Days Payables Outstanding (DPO), which in turn, has a profound effect on the company’s working capital and cash.

In this article, we will cover the following:

  • What’s the financial impact of supplier payment terms?
  • How can companies turn DPO into a source of cash for growth?
  • How can supply chain and procurement professionals assess the right supplier payment terms (simplified example)?

Financial Impact of Supplier Payment Terms

Supplier payment terms translate into accounts payable. This is what the company owes to its suppliers. For example, the company receives the packaging material that it had ordered but hasn’t paid the supplier yet.

This dollar amount owed goes into accounts payable. Accounts payable represents liabilities that you can find on the company’s balance sheet.

In general, as they are due in less than a year, they are part of the current liabilities. When the company extends payment terms to suppliers, accounts payable goes up.

Mature S&OP processes—also known as Integrated Business Planning (IBP)—have a strong integration with finance and include financial metrics in addition to operational metrics.

A common cash metric is DPO. It shows the number of days from inventory purchase until the payment to supplier.

For this metric calculation, you will need cost of goods sold (COGS) that you can find in the Income Statement or Profit and Loss Statement (P&L). The calculation of DPO is as follows:

DPO = (Average Accounts Payable/ COGS) X 365

The result is in number of days. For example, if after plugging in average accounts payable and COGS, DPO equals 75, it implies that it takes 75 days for the company to pay its suppliers from the inventory purchase.

Provided that COGS remains the same, when companies extend payment terms to suppliers, DPO will be higher.

DPO as a Source of Cash for Growth

DPO is a component of another common metric in S&OP/ IBP that is the cash conversion cycle (CCC). CCC conveys how many days it takes for a company to convert its investment on inventory into cash. This metric is as follows:

  • CCC = DIO + DSO – DPO
  • DIO = days of inventory outstanding
  • DSO = days of sales outstanding
  • DPO = days of payables outstanding

Like DPO, CCC is in number of days. For example, a CCC of 90 implies that it takes 90 days for the company to convert its investment on inventory into cash.

When companies have extended DPO, it shortens CCC and can even make it negative. In this situation, companies are turning liabilities into a source for growth without interest expense, if the economic conditions remain stable.

Amazon has financed part of its growth with DPO, for example. Building relationships with suppliers include negotiating payment terms.

Although extended payment terms can represent a long stretch for suppliers, there are other factors to consider including profit margin, volume, growth potential, and brand awareness.

Assessing the Right Supplier Payment Terms

A Request for Proposal (RFP) may include a certain number of days for supplier payment terms as a requirement. This implies that when suppliers submit their response to the RFP, they must accept such payment terms and bid accordingly.

Other times, the company is willing to negotiate payment terms, not having a set number as requirement. When this happens, suppliers can offer different pricing conditions for the supply chain and procurement team to assess.

As an example, the supplier suggests three options:

  1. Without terms – $100
  2. 30-day terms – $100.75
  3. 60-day terms – $101.50

Logically, supplier’s price is higher when payment terms are longer. To initially assess which option is best, it is critical to know the average cost of debt rate that the company has, as the company may work with more than a bank.

For our simplified example, let’s consider that the average cost of debt rate is 5.25% annually.  This means 43.75% monthly. In this case, the company would be better off buying from the supplier without terms.

A cash flow forecast follows this initial assessment to define if it is feasible to make the supplier payment.

It is not enough with looking at the working capital—current assets deducted by current liabilities—as the company can have a significant portion in inventory.

Conclusion

Days Payables Outstanding (DPO) has a significant effect on working capital and cash, as shown per the Cash-to-Cash Conversion (CCC) metric.

CCC conveys how many days it takes for a company to convert its investment on inventory into cash. Extended DPO can lead to short or even negative CCC.

This implies that companies in such a situation are turning liabilities into a source for growth without interest expense, if the economic conditions remain stable.

The company’s average cost of debt and cash flow forecast are critical in the financial assessment of different payment terms and cost.

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