In primitive accounting methods, the cash basis of accounting was a general practice. Either expenses or income was recorded once the cash was involved in the transaction. What is meant to say, if a sale occurs, it will not be registered as a sale in the accounts until the buyer pays the cash.
It adds a lot of inconvenience to the bookkeeping and financial analysis. On the one hand, the bookkeepers have to maintain different books for recording transactions. Simultaneously, the cash basis results are less accurate and do not reflect actual income or expenses.
However, the accrual accounting method was introduced to make business transactions and bookkeeping convenient. The accrual accounting method is the most commonly used with the basic characteristic of a true reflection of a business entity’s income or loss. It is built on basic accounting principles to ensure true and fair representation of financial position.
Under accrual accounting, all the transactions, cash or credit, are recorded in the books of accounts. Regardless of when cash is received or paid, the business entity’s income statement and balance sheet reflect the truest view of financial health and position.
Accounts payable and accounts receivables are the most common factor in accrual-based accounting. Accounts payable corresponds to the services taken or purchased products yet to be paid for.
Although, the accrual accounting method solved the true-reflection problem. However, the comparison of different companies by different stakeholders is also critical. It is uncertain whether a company is good or bad merely looking at account payables or account receivables. Therefore, financial ratios help assess a business compared to other companies working in the same industry.
This article is all about the account payable turnover ratio and how does it help stakeholders.
What Is Account Payable Turnover Ratio?
The account payable turnover ratio is a liquidity ratio. The liquidity ratios generally measure a business entity’s ability to meet its debt obligations(short term). These ratios give useful insights to the creditors and investors of the company to issue debt or make an investment.
The account payable turnover ratio can be described as,
It is a liquidity ratio that measures how fast a business entity pays to the suppliers and creditors for extended lines of credit. More appropriately, the account payable turnover ratio is the average number of times a business entity honors its account payables balance during a specific period.
For instance, the company’s account payable turnover ratio can be found yearly, bi-annually, monthly, etc. The account payable turnover ratio shows a business entity’s cash management practices.
Why Calculate Account Payable Turnover Ratio?
A question might arise as to why a business entity needs to calculate its account payable turnover ratio. When the balance sheet of a business entity clearly states the accounts payable balance, why calculate the account payable turnover ratio?
Here is the answer.
Any outsider, investor or creditor, cannot make a rational decision by just looking at a company’s cash, sales, or even account payables. Firstly, the higher account payables of a company might suggest that they are in a big problem. But it can be just the case opposite. The higher accounts payable might be due to a reasonable payment policy and quick payback periods of the entity. Similarly, the lower account payables aren’t always good.
Secondly, the concept of materiality is very critical in assessing different companies or industries. For instance, a creditor might believe that a company has higher accounts payable. But the amount might not be material compared to the company’s size.
For all these reasons, the creditors need to know how good the company is as a debtor. Therefore, an unbiased and explicit method of assessing a company’s payback ability is required.
Accounts payable turnover ratio is that method to assess the payback ability regardless of the company’s size, industry, and amount.
Formula For Calculating Account Payable Turnover Ratio
The following simple formula can calculate the payables turnover ratio,
Account payable Turnover Ratio = Net Credit Purchases / Average Accounts Payable
The average account payables are the average of the specified period. It can be calculated as,
Average Accounts Payable = (Beginning balance + Ending balance)/2
The net credit purchases, as mentioned, can be replaced with the cost of goods sold for merchandising business if all goods purchased were on credit. The net credit purchases can be calculated as follow:
Net Credit Purchases = Credit Purchases – Purchases Returns
Interpretation Of Account Payable Turnover Ratio
Financial ratios are extensively used to analyze and assess a company’s credit history by the creditors. Moreover, it also represents how well a company is doing in its cash flows. It measures the short-term creditworthiness of a business entity. The AP turnover ratio can be interpreted as follow:
Best Value For Account Payable Turnover Ratio
There cannot be an absolute value as the best value when it comes to ratios. Analysis can be made based on the permissible ranges, increasing or decreasing trends, etc. Therefore, no absolute value is considered best for the AP turnover ratio. However, a higher value is considered better for AP turnover.
For instance, if the value of the AP turnover ratio for a financial year is 4.7, it means that the company had completed 4.7 cycles during a financial period. It can be converted into days by dividing 365 by the account payable turnover ratio.
Increasing Account Payable Turnover Ratio
The increasing trend is shown in the AP turnover ratio over the historical period reflects the improvement in its paying back ability. For instance, if the account payable turnover ratio was 3.4, 5.7, 7.9 for the three consecutive years, it will indicate that company has been paying its debt more quickly.
The higher AP turnover might mean that company is taking advantage of trade discounts by early payments, or creditors might be allowing a smaller payback period.
Decreasing Account Payable Turnover Ratio
The sluggish trend of AP turnover ratio or a lower value indicates that the company might be stressed regarding its cashflows. The sluggish cashflows can be the potential reason for lower AP turnover, but it might not be the case. The creditors might have allowed favorable terms of credit that are leveraged by a business entity.
Examples Of Account Payable Turnover Ratio
Let’s comprehend the concept with an example.
Peter & Sons Building Material Sellers purchase equipment and raw material from different wholesale sellers and then throw them in the retail market. It is a common practice for them to have credit purchases.
For the year 20XX, it was found that total credit purchases from multiple vendors were $15,00,000. The beginning account payables were $100,000, and the closing balance was $13,00,000.
What will be the AP turnover ratio?
We can calculate the ratio as follow:
Average Account Payable = $100,000+$13,00,000/2
Average Account Payable = $700,000
Let’s find out the AP turnover ratio:
Account Payable Turnover Ratio= $15,00,000/$700,000
Average Account Payable Ratio = 2.14
The value of 2.14 suggests that Peter & Sons paid around two times during the financial period. It might be at an interval of six months.
Tracking Account Payable Turnover Ratio
The companies can keep track of their account payable turnover ratio for the financial period. It will help them improve their AP turnover so that external stakeholders view them as a favorable business for investment or credit granting. It is up to a company how it tracks AP turnover internally. AP turnover can be estimated in days, annually, bi-annually, or quarterly.
Suppose a business entity is looking to extend its line of credit. In that case, it is critical to analyze its account payable turnover ratio and take corrective actions to get favorable terms of credits from the creditors. Therefore, paying close attention to AP turnover is crucial for a business’s financial position and health.
AP turnover is an excellent financial liquidity ratio. However, there are some limitations posed by this ratio. When the stakeholders demand a positive and higher value of AP turnover ratio, it is not a sunny day inside the company.
It might be time to explain when a company has a higher ratio of paying back its creditors than the industry average. It signals that the company is not utilizing its cash flows to maximum productivity, which can hurt the business.
A business entity can always work toward improving its account payable ratio to be at optimum value. As discussed, too much high value and a lower value are not good for the internal and external affairs of the business.
Therefore, the companies need to take corrective actions to improve the values. Internal audits for productive use of cash and cash management can help to maintain an optimum AP turnover.
Furthermore, a lower AP turnover might be corrected by revising the collection terms and policies. A low AR turnover might be the cause of delays in paybacks. Similarly, other corrective actions like terms of credits, improving the cost of goods sold can also help in better AP turnover.