How to calculate creditor days - formulas and examples
There are many potential challenges for small businesses - one of these is often cash flow. According to a study by Jessie Haegen of the US bank, 82% of small businesses fail because of poor cash flow management skills. Given the importance of solid cash flow management, this article will explain creditor days – a key metric that can be used to measure how well a business is managing its trade credit with suppliers.
What are creditor days?
Put simply, creditor days – also called ‘payables days’ or ‘days payable outstanding’ (DPO) – refers to the average number of days it takes your business to pay your suppliers. Creditor days impact your company’s cash flow – as by waiting longer to repay suppliers, there is greater working capital on the balance sheet. Let’s take an example:
A restaurant will often buy ingredients from suppliers on trade credit without immediate payment. The supplier then becomes a creditor to the restaurant, with the money owed for the ingredients bought needing to be repaid at some point. As this process repeats itself, the restaurant's creditor days are the average time it takes for this repayment to occur.
What does the creditor days ratio show?
Since the creditor days ratio shows the average amount of time to repay suppliers, it indicates how well your company’s cash outflow is being managed. In this sense, it reveals how well your company is balancing your need for cash with your suppliers’ needs for repayment, reflecting your creditworthiness.
Calculating creditor days
What you'll need to calculate creditor days
There are three main elements to calculating creditor days: trade payables, cost of goods sold, and time period.
Trade payables are amounts of money – the outstanding credit - that your business owes to suppliers for inventory-related items. This includes ready-to-be-sold products and the raw materials required to make them.
It is important to know the difference between trade and accounts payables when you calculate your trade payables. Accounts payables include all short-term debts, including money owed for non-inventory related items. Therefore, when you use accounts payables, the figure could be higher than the trade payables, potentially leading to an inaccurate creditor days ratio.
Returning to our restaurant example, whilst debt for ingredients would be trade payables, money owed to companies that maintain the restaurant building would fall under the wider accounts payable category.
Cost of goods sold (COGS)
The costs of goods sold are the costs that directly arise from creating the goods and services that are sold.
In our restaurant example, the COGS would include the raw ingredients, the condiments, and the garnishes.
The creditor days ratio is displayed over a certain time period, typically a year or fiscal quarter.
How do you calculate creditor days?
Now, for the magic formula:
Creditor days = (Trade Payables / COGS) * Time Period
where COGS equals:
Cost of Goods Sold = Beginning Inventory + Purchases – Ending Inventory.
We can see how this formula works in an example. Say you had £200,000 of trade payables and £10,000,000 cost of goods sold over a year, then the creditor days ratio would be 73.
This is because: (200,000/10,000,000) x 365 = 73
What is a good creditor days ratio?
Should creditor days be high or low?
A ‘good’ creditor ratio shouldn’t be too high or too low. If it is very high, it means that your company is waiting a while to repay your debts, which may damage relationships with suppliers and even result in fines for late payments or termination of supplies in the future.
Meanwhile, if it is very low, it means that your company is repaying unnecessarily soon, hence reducing the amount of cash available for other projects and investments that might be useful to you.
Is it good to have high creditor days?
With the above being said, it is generally better to have a slightly higher creditor ratio to have greater working capital with which to operate on. There is no concrete number to aim for, but around 30-60 is a generally accepted bracket.
However, where you strike a balance depends on your specific business needs. For instance, the finance department has an incentive to delay payment for as long as possible, whereas the production department wants to ensure a smooth production process and so is eager to not damage the relationship with suppliers.
How to improve creditor days
There are several ways you can improve your creditor days:
1) Renegotiate payment terms
As you build rapport with suppliers, it is easier to negotiate more relaxed payment terms, which can be quite harsh at first. To achieve this, it is necessary to generate a positive relationship with suppliers, such as communicating about payment delays ahead of time or paying vendors in their preferred payment method.
While effective, this approach understandably takes time and can be limited as some suppliers have stringent payment policies that they cannot deviate from.
2) Have continuity plans for liquidity
By having accurate sales and spending forecasts for each quarter, you can minimise the amount by which you have too much or too little working capital, thus reducing the risk of having an extremely high or extremely low creditor ratio. This can be done by tracking inventory turnover, generating budgets, and planning total spend.
This approach is particularly useful for seasonal businesses whose cash flow can vary wildly throughout the year.
3) Outsourcing & automation
When it comes to repaying creditors, one option is to externalise control. This can be done by outsourcing to a human accountant or using cloud accounting like Xero.
Cloud accounting packages often come with inventory management support too. This tracks inventory turnover to eliminate excess inventory, which can tie up working capital and inflate your creditor days ratio if undetected.
Whether you outsource to an accountant or opt for an automated process, the result is the same: both help pay bills on time, keep creditors happy, avoid late fees, and stabilise supply chains.
Limitations of creditor days ratio
Ultimately, it’s difficult to know the optimal creditor days ratio. Not only does it depend on your company’s situation, but it varies highly between industries that have different patterns of cash flow. External factors, such as downturns in the overall economy, can also impact annual creditor ratios, making it hard to reach the right conclusion on what your creditor ratio is really showing.
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