Companies can unlock value by optimizing their DPO. Note that I said “optimizing” and not “increasing” or “decreasing.” While companies generally want their days sales outstanding (DSO) and days sales in inventory (DSI) to be as low as possible, the optimal DPO is neither too high nor too low.
So what is the optimal DPO? The optimal DPO is the DPO that allows the company to:
• Take advantage of early payment discounts when appropriate
• Delay payment until it is due, thereby shortening the cash conversion cycle
• Maintain good relationships with suppliers
Early payment discounts
Suppliers frequently offer discounts to incentivize early payment. For example, a supplier that offers credit terms of “2/10, net 30” is offering a 2% discount if the supplier receives payment within 10 days.
Not all early payment discounts are attractive enough to merit paying early; a company should weigh the benefits of paying early against the benefits of retaining cash for longer. As part of this analysis, the company should calculate the interest rate that is effectively being incurred by forgoing the early payment discount.
Delay payment
Companies should strive to retain cash and delay payment of suppliers as long as possible unless there is a sufficiently attractive discount to justify early payment. Delaying payment of suppliers increases the amount of cash on hand, and that cash can be used to:
• Finance growth (product development, acquisitions, new projects, etc.)
• Invest in securities and earn a return
• Pay off short- or long-term debt
• Make a distribution to shareholders
• Improve liquidity for market shocks
If a supplier offers payment terms of “2/10, net 30” there is no benefit to paying the supplier on day 2. Even if the company finds the discount to be attractive and wishes to pay early, the company should pay as close to day 10 as possible. By allowing the company a grace period before payment is due, the supplier is essentially offering the company an interest-free loan. Companies should take advantage of the grace period and pay when the money is due.
Delaying payment until the money is due also shortens the company’s cash conversion cycle, which means the company will require less financing (this could reduce the company’s short-term borrowing costs).
Good relationships with suppliers
While a company can shorten its cash conversion cycle by delaying payment, a company shouldn’t delay payment so much that it damages relationships with its suppliers. Late payment can result in penalties, slower delivery times, and unfavorable payment terms (e.g., “cash on delivery” or “cash before delivery”). In extreme cases the supplier may even refuse to do business with the company going forward. Thus, there is a limit to the benefit of stretching out payment terms, and companies must be careful not to destroy relationships with suppliers.
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