An account payable turnover ratio helps to measure the time business takes to pay off the debt to the creditors. It helps the business to understand the pattern of the payments and how they fast are in making payments to the creditors.
It’s a widely used liquidity metric to get an idea about payment patterns and understanding of the business that is struggling to pay off for the creditors. The calculation can be of great importance to the suppliers as they can assess the credibility of the business in paying creditors before entering into a selling contract with them.
The rapid payments of the accounts payable are considered to be ideal. however not so rapidly that the business misses opportunities since they could utilize the cash and generate profit. So, adequacy is not about paying fast it’s about paying on time.
Decrease in the accounts payable turnover ratio
The diminishing trend of the accounts payable flags that the company might be facing some monetary troubles and not able to pay for the debts falling due. On the other hand, the company may have negotiated the extended terms for the payments with the suppliers. So, operational information needs to be considered in the appropriate interpretation of the ratio.
Increase in the account payable turnover ratio
The increasing trend of the accounts payable suggests that the company is paying the suppliers more efficiently than the previous period. This might suggest that the company has enhanced the mechanism of cash management and the activities adversely affecting the liquidity position of the business.
On the other hand, the suppliers might have reduced the credit terms for the business due to an increase in the demand for their products.
Formula
Payable Turnover Ratio = Credit Purchases / Average Account Payable
Interpretation
The accounts payable turnover ratio is an activity ratio that measures how many times per year the company pays its average debt to suppliers. If the ratio is higher the company makes prompt payment to the creditors, it’s indicated by the lower accounts payable as most of the portion has been paid to the creditors in comparison with the purchases.
On the contrary, if the ratio is lower it indicates that payable is higher which has not been paid for a larger period. In other words, the proportion of the payable is more in comparison with the credit purchases.
Example
Consider the business had payable outstanding on the opening of the year 2020 amounting to USD30,000 and closing at the year amounting to USD20,000. The credit purchases during the year amounted to USD70,000. Let’s calculate the accounts payable turnover ratio with the formula.
Payable Turnover Ratio = Credit Purchases / Average accounts payable
Payable Turnover Ratio = USD70,000 / {( USD20,000 + USD70,000)/2}
Payable Turnover Ratio = USD70,000/ USD45,000
Payable Turnover Ratio = 1.56 Times
The business paid 1.56 times during the past year as per calculation. Although, the frequency of the payment does not seem to be higher. However, it needs to be compared with the peer companies in the industry.
Use as Key Performance indicator – KPI
An accounts payable ratio can be an excellent key performance indicator to assess the performance of the cash management mechanism.
If the managers successfully maintain the accounts payable turnover ratio, it should present be an indication for good performance of the manager as they have contributed to the effective management of the cash.
Certain benchmarks can be set for the accounts payable turnover ratio to ensure the sustained performance of the working capital management.
Use in the financial analysis
Assessment of liquidity is one of the most important concepts of financial analysis. The payable turnover ratio helps to identify the risk of liquidity and going out of cash for the payments.
When combined with accounts current ratio, it provides analysts the basis to conclude the performance of the business in terms of liquidity.
Accounts payable days
The accounts payable ratio can be converted into the accounts payable days by dividing the ratio by 1 and multiplying with 365. This calculation converts the proportion of purchases and payments in the days.
The calculation in days is effective when receivable days are compared with the payable days to assess if the business is lacking ineffective management of the capital.
Advantages
- The accounts payable turnover ratio helps to assess the performance of the working capital.
- It helps to enhance the profitability of the business by finding gaps in cash management.
- It helps to eliminate operational interruption in the use of working capital management.
- By maintaining timely payment of the suppliers, the value of the company increases in the market, and suppliers feel confident about timely receipts of their dues.
- It can be used as an excellent KPI to assess the performance of the managers in terms of working capital management.
- When used with other activity ratios like inventory turnover days, receivables turnover days, and payable turnover days, it helps to assess where is the gap in capital management. For instance, the business might not be able to collect receipts from the customers and facing difficulty in the payments of the creditors.
Limitations
- Some components of the formula like credit purchases are not available in the annual report. So, it may be difficult for the potential supplier to assess the payment frequency.
- It’s difficult to compare the accounts payable of two companies as these companies may have different policies of working capital management. For instance, one company may have the policy to reinvest the proceeds before making payments to the creditors while another company might not be. So, the comparison may not be like by like.
- Sometimes, there are business reasons for not paying the suppliers on time. It might be interpreted by the analyst as the inefficiency of the business while it may be simply due to some mutual understanding between the suppliers and the business. For instance, the business and suppliers might agree to extend the credit terms as the business has agreed to purchase material in the bulk.
