Upward Trending Days Payable Outstanding: A Cause for Pause?

Credit & Financial Management Review, Fourth Quarter 2008 by Ricci, Cecilia Wagner PhD

Abstract

Financial theory states that an upward trending Days Payable Outstanding ratio is an indication of effective cash management because it means that a firm is holding on to its cash as long as possible. Yet some practitioners argue that an upward trend is evidence of cash flow difficulties. Utilizing the S&P 500 as the sample and the cash conversion efficiency ratio as a measure of cash flow, this research attempts to determine whether an upward trending Days Payable Outstanding ratio is an encouraging sign or a warning sign.

Introduction

In 1906, Post (1906) suggested that bankers "scrutinize closely" a company's accounts payable before lending it money. More than a century later, accounts payable should still be scrutinized because they are critical to corporate survival. This is especially true in the current economy because short-term credit is substantially more difficult to obtain.

A key issue regarding accounts payable is the disparate views between academia and some practitioners. Financial theory states that taking longer to pay accounts payable is good cash management because the firm is holding its cash for longer, yet some practitioners argue that such firms have cash flow problems. The study uses empirical testing to attempt to end this controversy. As such, this research should be of interest to faculty teaching corporate finance or short-term financial management, as well as practitioners in the working capital or treasury fields.

The remainder of the paper is arranged as follows: the next section reviews the previous literature; the third provides information on the sample and time frame and is followed by the methodology utilized. The penultimate section presents the results, and the final section contains the conclusion, including the implications of the study, its limitations, and suggestions for future research.

Literature Review

The importance of managing working capital properly is well established in the literature. For example, Aheam (2008) calls working capital the "key to any organization." Lazaridis and Tryfonidis (2006) report that there is a link between profitability and how working capital is managed. Reason (2005) says that working capital drives growth. And Mintz (1999) says that the largest force in financial management is working capital.

The management of working capital generally concentrates on managing the cash conversion cycle (CCC), also known as the "cash gap" (Birnbaum, 2007), which is

Day 's inventory held day 's sales outstanding - day 's payable outstanding; often abbreviated as

DIH DSO-DPO

The focus of this paper is the last variable, days payable outstanding or DPO, which is defined as the number of days it takes a firm, on average, to pay its accounts payable. The determination of a firm's DPO is straightforward:

Accounts payable daily cost of sales

Financial theory states that firms should extend their DPOs for as long as possible. Hill and Sartoris (1992) operationalize this tenet using the equation

Maximize the net present value of operating cash inflows - operating cash outflows

They note that in attempting to maximize this objective function for short-term financial management, financial managers will speed cash inflows and slow cash outflows. Maness and Zietlow (2006) concur, saying that "...the expansion of working capital liabilities accounts provides resources." And Reason (2005) says that a positive change in DPO is an improvement.

Yet there are some negative views of stretching payables. For example, a 1999 IOMA report says that, "Some CFOs feel that an increasing DPO figure gives the impression that the company is experiencing operating difficulties" (New Ways, 1999). Salima (2007) reports that in the UK, delaying payment to suppliers can be seen as "inefficient and even detrimental." Fink (2001) says that stretching payables can scare suppliers into declining to provide credit, and quotes the president of a consulting group as saying that stretching payables "can bite you in the rear end." Reason (2005) says that stretching payables can "hurt a company in the long run." Reason (2003) says that this practice "can lead to a gigantic, circular squeeze where no one wants to cut a check to anyone else." And some view long DPOs as "financial stress indicators" (Timing Payments, 1990). Glassanos (2003) reports that some companies are questioning the idea that an increasing DPO is "smart economics." Reason (2005) quotes Martin Jarvis of Unilever as saying stretching DPOs is counterproductive. And Gentry and De La Garza (1990) say that a rapid buildup in accounts payable can result in a loss of credibility.

Thus, the current situation is one in which financial theory dictates that increasing DPOs is desirable, yet some practitioners counter this view. The empirical testing concerning this issue is discussed below.

Sample and Time Frame

The research sample is the S&P 500. The data were obtained from the Compustat database. After removing companies with missing data, 313 companies across ten GIC (General Industrial Classification) economic sectors remained. As may be seen in Table 1 , the makeup of the initial sample mirrored the S&P 500, with the exceptions of the Consumer Discretionary and Health Care sectors, which have higher representation in the sample than in the S&P 500, and the Financials sector, which has a larger portion of the S&P 500. Also of note is that the Telecommunication Services sector contains only three companies. Consequently, it was removed from the sample, so the final sample was 310 companies in nine GIC economic sectors.