Accounts payable turnover ratio is the times a business clears its accounts payable balances in an accounting period.
The accounts payable turnover depends on the net credit amount and average accounts payable amount. Although there is no set rule to define the right turnover ratio, a business can analyze the AP turnover ratio trends and compare them against the industry benchmarks.
What is Accounts Payable Turnover?
Accounts payable turnover ratio refers to the number of times a company pays its creditors. Simply, it is the times accounts payable paid in an accounting period.
Businesses make inventory and supply purchases on credit terms. Different suppliers and creditors offer different credit periods to their customers. The sum of money owed by a business to its creditors is called accounts payable (AP).
The AP turnover is simply the ratio that defines how quickly a business clears its dues to its suppliers. A high ratio means a company pays quickly and a low AP turnover ratio indicates a company clears payables slowly.
When a company holds its payable amount, it utilizes cash. Therefore, a company would like to see a higher AP turnover. However, the true sense of AP turnover would depend on the type and nature of the business.
Also, businesses in different industries would witness different average AP turnover ratios.
Accounts Payable Turnover Formula
The accounts payable turnover formula can have different variations. However, the main components are the same for all formulas.
Accounts Payable Turnover = Total Supply Purchases / [(Beginning AP + Ending AP)/2]
Simplified AP turnover ratio formula can be written as:
Accounts Payable Turnover = Net Credit Purchases / Average Accounts Payable
Both formulas would provide the same result as the figures used will be the same although calculated differently.
AP turnover ratio can be calculated for any accounting period of monthly, quarterly, or annually.
How to Calculate the Accounts Payable Turnover?
You can calculate the accounts payable turnover with a step-by-step approach.
In the first step, you need to calculate the total credit purchases amount. Some businesses use the cost of goods sold amount here instead of credit purchases.
You can add all credit purchases for the accounting period you want the AP turnover ratio. Exclude all cash purchases and purchases already settled.
Calculate the average accounts payable amount. You can take the beginning accounts payable and add the ending accounts payable figure. Then, divide the sum by two to find the average accounts payable for the period.
Divide the net credit purchases by the average accounts payable figure to find the accounts payable turnover ratio.
The next step is an additional step where you can convert the AP turnover ratio into days payable outstanding (DPO). Divide the number of accounting days (90 or 365) by the AP turnover ratio to find the DPO.
Example of Accounts Payable Turnover
Suppose a company ABC purchases its inventory on credit terms from its suppliers. It has the following data available for its inventory purchases and accounts payable for the last year.
Total Credit Purchases = $ 3,000,000 Previous Credit Payments = $ 500,000
Net Credit Purchases = $ 3,000,000 – $ 500,000 = $ 2,500,000
Beginning Accounts Payable Balance = $ 120,000
Ending Accounts Payable Balance = $ 370,000
Average Accounts Payable Balance = ($ 120,000 + $ 370,000) / 2 = $ 245,000
The ABC company can calculate the AP turnover by using the formula:
Accounts Payable Turnover = Net Credit Purchases / Average Accounts Payable
Accounts Payable Turnover = $ 2,500,000 / $ 245,000 = 10.2 times
If the ABC wants to calculate its days payable outstanding, it can use the following formula:
Days Payable Outstanding = 365 /AP turnover = 365 / 10.2 = 35.78 days.
Interpretation of Accounts Payable Turnover
First of all, a company should determine the accounting period for which it wants to calculate the AP turnover ratio. The accounting period can be 30 days, 90 days, or 365 days for annual analysis.
Then, a business must analyze different metrics to determine a good AP turnover. For instance, a retail business will inevitably keep a longer accounts payable period. It should work with its supplier to extend the accounts payable period.
A high AP turnover ratio means a business is paying quickly to its suppliers. It also indicates it is paying suppliers more often. Contrarily, a lower AP turnover ratio means a business is paying its suppliers less frequently.
A high AP turnover means the business is not utilizing credit terms properly. Therefore, when a business fully utilizes its credit terms and keeps the AP turnover under control, it increases cash in hand.
Also, it should be noted that there are no set rules to define the perfect AP turnover ratio. Like other financial ratios, it should also be analyzed using trend analysis and benchmarking tools.
The right way is to compare the AP turnover ratio against historic results. Also, the company should compare the credit terms and the average accounts payable balances over the years to analyze the cash flows objectively.
Why is Monitoring Accounts Payable Turnover Important?
It is important for businesses to monitor their accounts payable turnover that work on credit terms with their suppliers.
Accounts payable turnover ratios can be interpreted differently. For instance, a high AP turnover ratio means a company has sufficient cash balance and is paying its invoices quickly.
The same high AP turnover may also mean that the company is not strategically utilizing the credit terms offered by its suppliers. Also, the company does not exercise negotiation powers with its creditors to extend the credit terms.
Similarly, a low AP turnover means a company is paying less frequently. It may mean that the company is fully utilizing the credit terms offered by its creditors. However, it may also mean that the company is struggling for cash.
Creditors and suppliers also keep an eye on the AP turnover ratio. They can extend credit terms if they see a positive trend in the AP turnover ratio of a business consistently.
In short, a healthy AP turnover ratio as compared to the industry benchmarks means good financial strength of a company. It gives creditors confidence and they may extend credit terms generously.
Accounts Payable Turnover and Days Payable Outstanding (DPO)
Days payable outstanding (DPO) also provide the same information as the AP turnover ratio. The DPO days tell how long a company takes to pay its creditors in the short term.
When you divide the AP turnover ratio by the number of days in the accounting period, you get the days payable outstanding. Therefore, both figures are directly related as far as the accounts payable management is concerned.
Both ratios basically depend on the length of the accounts payable period. Both ratios would improve if the company utilizes the credit period. For better results, the business should negotiate more favorable credit terms to improve the AP turnover ratio and DPO.
How to Improve Accounts Payable Turnover?
One way of improving the AP turnover is to balance the cash inflows and outflows. Also, when a business utilizes the credit terms, it manages cash in a better way.
Businesses should track their accounts payable trends that would reveal their cash management plans as well. Also, they must negotiate better credit terms with suppliers to fully utilize the credit periods.
A balanced approach for accounts payable and receivables is important for better utilization of cash balance.