Understanding Days Payable Outstanding (DPO): Why It Matters (or does it?) for Your Ecommerce Cash Conversion Cycle

Key Takeaways for Ecommerce Brands:

1. ‍The Days Payable Outstanding (DPO) metric appears to use the wrong denominator in its calculation - using COGS instead of inventory purchases - yet this seeming flaw doesn't affect its practical application for e-commerce businesses.
   ‍
2. While DPO and Accounts Payable Turnover (APT) are mathematical inverses, they unexpectedly use different underlying metrics in their calculations, creating an apparent theoretical contradiction.
   ‍
3. This inconsistency resolves itself within the broader Cash Conversion Cycle because the formula assumes all inventory is eventually sold, making COGS equal to inventory purchases over the complete cycle.

My goal as the Head of Education here at Finaloop is to help DTC founders make sense of critical and sometimes complex ecommerce accounting and financial concepts - and develop the financial literacy and accounting reports understanding that will help them run healthier businesses.

As such, from time to time, I will try to break down some important financial metrics, challenge their conventional interpretations, and show you how to adapt them specifically for e-commerce businesses.

And today we’re diving into “Days Payable” (part of the cash conversion cycle). Or, in other words, why the Days Payable Outstanding metric is wrong (and why it doesn’t matter).

Basics of the Cash Conversion Cycle

So, if we want to discuss Days Payable Outstanding (DPO), let’s start with some context. The DPO is part of the all-elusive cash conversion cycle. This pretty much meshes three different formulas together: days payable outstanding, days inventory outstanding, and days sales (also: receivable) outstanding.

What each of these means, is how much time lapses:

1. Between when you order and when you pay your suppliers (DPO)
2. Between when you order inventory until you sell it (DIO)
3. From when you sell your inventory until you collect the payment (DSO).

This, in other words, means that we are going to look at your procurement through sales and, last but definitely not least, how efficient your collection process looks. This is the backbone of your operations process.

Beyond the Basic Advice

Now, I’ve seen lots of online content explaining what the cash conversion cycle is, how to calculate it (DIO+DSO-DPO), how to aim for negative CCC and ways to improve your cycle. You’ll see a lot of websites discussing extending your vendor payment terms, which will give you trade credit. In really optimal circumstances, this can finance your inventory purchases (negative CCC). They will generally follow with generic advice on reaching out to customers to pay quicker (after speaking with your vendors, to pay later), some improvement to your inventory practice, etc.. and voila, there you have it - you’ve perfected the cycle.

While all of these are important, I have yet to see a deep dive into explaining the actual metrics and why it makes sense (does it?). And for any brand founders looking to develop some solid understanding of their business through financial metrics, this kind of deep dive is a must.

Deep Dive: Days Payable Outstanding (DPO)

And so, to do that, we'll first focus on the procurement side (DPO). DPO looks at how many days it takes, on average, for me to pay my suppliers. (The assumption is that some of the purchases are credit-based because if not, DPO would be zero.)

To understand why the DPO calculation might be problematic, let's first look at its relationship with Accounts Payable Turnover (APT). These metrics are mathematical inverses - DPO measures how long I take to pay, while APT measures how often I pay. Since they're two sides of the same coin, you'd expect them to use the same underlying metrics in their calculations. But as we'll see, this isn't the case.

The formula for AP Turnover is generally:

Credit purchases/Average AP

This leads us into the core of the issue. Let me explain how these calculations actually work and why it matters.

First, consider that my credit purchases in a given period are constant - as this is a P&L item. No matter when I purchase throughout the period, the total amount purchased will be the same.

In other words, if I am looking at the period of one year, whether I purchase an equal amount all 365 days, everything on day one, or everything on day 365 - the result will be the same - my total credit purchases in that period.

On the other hand, my AP during that period will (should) eventually decrease (unless you are planning on going cold turkey on your vendors). This is, because, when I pay back the vendor, I decrease my AP against cash. The faster the AP decreases, meaning the quicker you repay your vendor, the smaller your average AP will be over that period. Why? Because more days within the period will result in fewer accounts payable. It’s basic math - when a denominator is smaller than the numerator, which is static, the total is larger. That’s why the faster you pay back your accounts payable, the lower the denominator, and the higher the turnover.

Now, let’s inverse the formula for DPO. We’re doing it to see how to convert AP turnover (=how many AP turns in a period) to DPO (= the average amount of days my payables are outstanding).

DPO equals Average AP/COGS in a given period of time.

Meaning, in order to figure out how many days payable outstanding I have within my cash conversion cycle, I need to proceed as follows.

1. First, I need to calculate my average accounts payable for the period. 
2. Second, divide that number by my COGS recognized in that same period. 
3. Last - multiply that number by the number of days in the period (let’s say, a year).

In a similar manner to the AP Turnover, my average AP in the period depends on how quickly I pay my vendors back. The faster I pay them back, the lower the average AP will be, and vice versa. On the other hand, my COGS(the denominator) is a P&L item. This means, that if I sell all of my inventory that I bought (using vendor credit) during the cash conversion cycle, I will recognize COGS that correlate to that inventory. Which again, is a fixed P&L number.  

In this case, because the AP is the numerator and the denominator is static - the lower the average AP, the lower the numerator. When this number is multiplied by the period of time (let’s say 365 days), the total days payable outstanding will be lower, and vice versa.

For example, if my COGS over 1 year is $100,000 and my average AP is $50K, my AP turnover equals $50K/$100K*360=180. If I paid back my vendors faster, and therefore my average AP is only $30K, the equation would look like: $30K/$100K*360= 108. A DPO of 108 is clearly shorter than the DPO of 180, because I paid my vendors faster, and my average AP was lower.

The Catch: Turnover Metrics and Their Opposites

Where’s the catch? The other metrics of the CCC are exact opposites of the turnover metrics.

As we discussed above, besides DPO, the CCC comprises DIO (relating to inventory) and DSO (relating to sales).

DIO is the exact opposite of inventory turnover. DIO compares inventory to COGS in a given period (as the inventory decrease corresponds with the COGS recognition in a given period). Inventory turnover, on the other hand, divided COGS by average inventory in a specific period.

DSO also compares accounts receivable in a given period to credit sales. As you collect cash, the A/R reduces, compared to the sales that don’t - giving you the actual time taken to collect A/R). This is the inverse of the accounts receivable turnover formula.

Why COGS vs. Inventory Purchases Doesn't Matter

On the other hand, what DPO should really be measuring is my procurement efficiency. In other words, it should compare my accounts payable to my credit purchases and not to my sales. Therefore, I should be looking at my inventory credit purchases in the given period and not at my COGS). 

So why does DPO take COGS, and not inventory purchases into account? I am not sure (I’ve heard several theories). At the end of the day, in this case, it doesn’t make a difference.

Why?

Because the cash conversion cycle looks at the entire time taken to convert my inventory purchase into cash.

Meaning, the assumption baked into the formula is that the inventory is eventually sold. It may take a long time, you may have a terrible business model, but the assumption is that you eventually sell that inventory (and end up collecting the cash).

When the inventory is sold, you recognize a COGS expense against decreasing the inventory. So, if within that period of time, you sold all the inventory - and that is the cash conversion cycle’s assumption, your inventory purchased will equal your COGS.  However, if the cash conversion cycle doesn’t really reflect your sale of inventory, this could be skewed. This is obviously because your COGS won’t equal your credit purchases (as you will still have inventory on your balance sheet).

Therefore, as the CCC looks at the period from when you ordered your inventory until you collect the payment, the DPO can safely use COGS and be accurate. It may have made more sense to compare Accounts payable to inventory purchases (and not sales), but hey, Beckers can’t be choosers.