Sep 13, 2016

Cash flow management: Common drivers in DSO and DPO that should be tracked

September 13, 2016 - Chief among the responsibilities of finance organizations at all companies is the management of cash flow. Regular tracking of key measures in this area is important for aligning priorities and goals, including targets for improving days payable outstanding (DPO) and days sales outstanding (DSO). Both DPO and DSO are important, since, aside from cash flow, the dollar value of a single-day change in DPO and DSO combined with the cost of capital underscores the financial criticality to the organization.

Typically, retrospective analyses of DPO and DSO consider the major drivers of variation, including changes in credit policies, payment terms, compliance, contracts, and other factors. Hence, when targeting days improvements, organizations usually consider the necessary changes in these sorts of controllable levers. When DPO and DSO are tracked over time, changes in these values—especially unexpected changes—often cause concern. Should DPO unexpectedly climb, or DSO unexpectedly decline, managers worry they may be beholden to these new and more favorable results. Should, instead, these measures unexpectedly change unfavorably, a different set of alarms ring, as the impact on cash flow intensifies. The core issue, however, is that not all changes in DSO and DPO are entirely due to changes in policies, terms, compliance, etc. Sometimes, the variability is a function of the calendar itself.

  • The definition of DSO is the accounts receivable at the end of a time period divided by sales in that time period times the number of days in the time period
  • The definition of DPO is the accounts payable at the end of the time period divided by the cost of goods sold in that time period times the number of days in the time period

Variation of these KPIs use average receivables or average payables over time, average sales or costs of goods sold over time, or other related rolling averages. Nonetheless, from these formulas, it is clear that changes in DSO or DPO are primarily due to changes in receivables, sales, payables, or cost of goods sold. However, consider features of the calendar in the table below.

In this table the Non-Bank Days are the number of days in the month in which banks do not operate, which includes weekends and bank holidays. The column Bank Days are the number of weekdays in that month, which excludes bank holidays.

Suppose DSO or DPO changes from November to December. Despite the month-over-month reports in most dashboards, in the above table we see that there are 3 more banking days in December, which has 22, than November, which has 19—an increase of 16%. This means that even if each business day business operates as usual, all else equal there should be 16% more spending (on the payables side) and 16% more sales (on the receivables side), and a corresponding reduction in the payables or receivables. This alone calls a warning to those attempting to interpret a change in DSO or DPO from November to December: the 16% swing in the denominator and numerator of the DSO and DPO formulas is due to bank day differences.

The table calls attention to another important phenomenon. The highlighted rows in the above table are those months whose last day falls on a weekend (a non-banking day). Payments due the last day of these months cannot be made on that date; instead, they must be made early or late, because of the calendar. If paid late, then the receivables or payables will be carried into the next month as would the sale or the cost of goods sold. In the case of November 2015, it could thus be impacted by the fact the prior month ended on a weekend. Hence, the October 2015 weekend-close impacts November 2015 DSO and DPO due to calendar issues, not credit policy changes, term changes, etc. In other words, comparing the November and December metrics requires an awareness of the ways in which these metrics are doubly impacted (by differences in banking day counts and month-end being a weekend).

There are other characteristics of the calendar just as important. Consider the following table:

Like before, when comparing the financial metrics year over year, we see the same month in different years can even have a different number of banking days. In some years, it is impacted by having a weekend as the last day, while in other years it is not.

Unique to each vertical are calendar cycles, events, and other time-linked attributes that can considerably impact critical business KPIs. Certainly, an interpreter of DSO and DPO metrics must align their KPIs to the calendar for a more holistic view, and not solely rely on trying to understand the standard levers that drive the inputs. In reality, since every month is impacted differently by the calendar, this must be factored into almost any analysis of DPO and DSO.

About the author

David Hauser, PhD

David Hauser, PhD

Chief Science Officer, CPG and Specialty Analytics

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