The Supplier Squeeze: Companies Are at It Again
Eight companies that are stretching their payables
Subscribers are well aware of our belief that earnings quality is an often overlooked aspect of financial analysis. While many investors focus on headline numbers such as revenue and EPS, the underlying quality of those figures is critical for understanding the sustainability and reliability of a company’s performance. Unfortunately, not enough attention is given to this important factor.
However, even investors who are aware of the importance of earnings quality often rely too heavily on cash flow conversion ratios as proxies for earnings quality. The rationale behind these ratios is intuitive: if earnings are being rapidly converted into cash, they are presumed to be of higher quality. However, this approach has a significant blind spot- it fails to account for the fact that cash flow itself can be of poor quality. For example, changes in working capital accounts such as accounts payable can distort cash flow figures, leading to a misleading picture of earnings quality.
In the weeks ahead, we will delve deeper into the nuances of cash flow quality. Today, we will take a look at the analysis of accounts payable. By examining how companies manage their accounts payable, we can uncover important clues about the quality of their cash flow and, by extension, their earnings. We will also examine eight companies below that appear to have received temporary benefits from extending payables in the last few quarters.
We believe this is a timely topic as rising days payable was a more prevalent red flag in our screening of third-quarter results.
Measuring Payables- The DPO Ratio
One key measure to consider when analyzing accounts payable is the days payable outstanding (DPO) ratio. This ratio is calculated as:
DPO = (Payables × Number of Days in the Period) / Cost of Sales
The DPO essentially measures the average number of days it takes a company to pay its suppliers. It provides valuable insights into how efficiently a company manages its payables and cash flow.
Companies often disclose their standard payment terms in their annual 10-K filings, which usually range from 30 to 90 days. Investors should closely monitor the DPO ratio for any significant upward movements, particularly if it approaches the upper limit of the company’s stated payment terms. Such a trend may indicate that the company is extending payment terms with its suppliers to maximize cash flow. We will discuss how to interpret a rising DPO in more detail below.
Low Rates During ZIRP Drove the Extension of Payables
During the mid-to-late 2010s, declining short-term interest rates encouraged many companies to extend their payables to historically high levels. Low borrowing costs made it inexpensive for suppliers to carry outstanding receivables, enabling companies to delay payments with minimal repercussions.
The extension of payment terms was further accelerated by the use of supply chain financing arrangements, also known as reverse factoring. Under these arrangements, a company sets up deals with third-party financing institutions that allow its suppliers to sell their receivables to the finance company to get their cash earlier at a small discount based on prevailing interest rates. The company then pays the finance company back under the original payable terms. Companies could extend the terms of their payables, yet the customers could still get their cash early at a small cost- as long as interest rates remained low.
From the mid-2010s to Covid, we saw DPOs for many companies steadily rise to historical levels. The proliferation of supply chain finance arrangements became so widespread that the FASB got involved, decreeing that starting in 2023, companies had to disclose the existence of such arrangements, the key terms, and the amounts outstanding at the end of the period.
We warned in past reports that this would come to an end when interest rates began to rise and suppliers were no longer willing to accept the higher costs to wait for their money. Not surprisingly, following an increase in rates 2022, the growth in payables reversed for many companies in 2023. However, soon after short-term rates began to head down in the late spring of 2024, we began to see another uptick in payables. Rising DPOs was a key flag turning up in our screening of third-quarter results.
What’s Wrong With Stretching Payables?
There is nothing inherently wrong with a company minimizing working capital by taking as long as it reasonably can to pay its bills. That’s prudent working capital management. However, a rapid increase in DPOs or stretching payables to unsustainably high levels can significantly distort results. An analyst should always ask the following questions when analyzing financial results:
Are rising DPOs distorting cash flow growth?
Consider a company that sees its payables rise from 60 days to 100 days over three years with no change in the amount of inventory it carries or the time it takes to get paid on its receivables. The rise in payables will provide a significant tailwind to cash flow growth as cash flow is coming in at the same rate as it was before, but the company gets to keep it an additional 40 days before paying its suppliers. The problem is that the company can only pressure suppliers so far before they begin to push back or demand higher prices to offset the cost of financing their receivables. When payables growth levels out, the boost to cash flow growth will be gone. Worse yet, if the environment changes (say interest rates increase) then DPOs may contract and become a cash flow headwind that many may not be anticipating.
Are payables rising independently of inventory?
Analysts must also consider the changes in payables in light of inventory fluctuations. If DPOs rise by 10 days y/y but inventory jumps by a similar amount, this is less of a concern. The boost to cash flow growth from rising payables is roughly offset by the drain on cash flow from rising inventories.
Is the increase in payables keeping a material amount of what should be viewed as debt off the balance sheet?
Again consider our example company above which saw payables rise from 60 days of payables to 100. In addition to receiving a boost to its cash flow, its balance sheet position has been impacted as it has essentially financed itself with short-term debt. We have seen several companies that have promised debt reduction see a decline in their long and short-term debt balances and tout their reduction in leverage. However, in the same time frame, they have ramped payables up as much as headline debt came down. That’s not real debt reduction. The company has simply refinanced itself with shorter-term, more volatile debt. Ratings agencies may ignore small changes in payables but when they start to grow significantly, the ratings agencies and bankers notice that and will often not fully credit a drop in financed debt if the company has largely transferred it to payables.
Analysts should always consider significant moves in payables when examining changes in a company’s leverage position.
Did the company use the extra cash to accelerate the buyback and drive EPS growth?
What if the company in the above example doesn’t reduce debt, but rather accelerates its buyback? This reduces the number of shares and accelerates EPS growth. However, when it is no longer able to expand its payables, the excess cash flow growth will dissipate, making it more difficult to maintain the new buyback pace.
Below we will explore the above questions to examine eight companies that have seen material increases in their payables balances that have distorted cash flow growth and the balance sheet.