Definition of Accounts Payable Turnover Ratio
Accounts payable turnover ratio is an accounting liquidity metric that evaluates how fast a company pays off its creditors (suppliers). The ratio shows how many times in a given period (typically 1 year) a company pays its average accounts payable. An accounts payable turnover ratio measures the number of times a company pays its suppliers during a specific accounting period.
Accounts payables turnover trends can help a company assess its cash situation. Just as accounts receivable ratios can be used to judge a company’s incoming cash situation, this figure can demonstrate how a business handles its outgoing payments.
Meaning of Accounts Payable Turnover Ratio
Accounts payable turnover is a ratio that measures the speed with which a company pays its suppliers. If the turnover ratio declines from one period to the next, this indicates that the company is paying its suppliers more slowly, and may be an indicator of worsening financial condition. A change in the turnover ratio can also indicate altered payment terms with suppliers, though this rarely has more than a slight impact on the ratio. If a company is paying its suppliers very quickly, it may mean that the suppliers are demanding fast payment terms, or that the company is taking advantage of early payment discounts.
The accounts payable turnover ratio shows investors how many times per period a company pays its accounts payable. In other words, the ratio measures the speed at which a company pays its suppliers. Accounts payable is listed on the balance sheet under current liabilities.
Investors can use the accounts payable turnover ratio to determine if a company has enough cash or revenue to meet its short-term obligations. Creditors can use the ratio to measure whether to extend a line of credit to the company.
Calculating the Accounts Payable Turnover Ratio
Accounts-payable turnover is calculated by dividing the total amount of purchases made on credit by the average accounts-payable balance for any given period. The formula is:
Accounts payable turnover ratio = Total purchases / Average accounts payable
Accounts payable turnover ratio = Total purchases / ((Beginning accounts payable + Ending accounts payable) / 2)
There is no single line item that tells how much a company purchased in a year. The cost of sales in the income statement (statement of comprehensive income) shows what was sold, but the company may have purchased either more or less than it eventually sold. The result would be either an increase, or a decrease in inventory. To calculate the purchases made, the cost of goods sold is adjusted by the change in inventory as follows:
Purchases = Cost of sales + Ending inventory – Starting inventory
Again, as with the accounts receivable turnover ratios, this can be expressed in terms of a number of days by dividing the result into 365:
Days Payable Outstanding (DPO) = 365 / Accounts payable turnover ratio
Example of Accounts Payable Turnover Ratio
Company ABC reported annual purchases on credit of $123,555 and returns of $10,000 during the year ended December 31, 2019. Accounts payable at the beginning and end of the year were $12,555 and $25,121, respectively. The company wants to measure how many times it paid its creditors over the fiscal year.
Accounts payable turnover ratio = ($123,555 - $10,000) / (($12,555 + $25,121) / 2) = 6.03
Therefore, over the fiscal year, the company’s accounts payable turned over approximately 6.03 times during the year. The turnover ratio would likely be rounded off and simply stated as six.
Cautions Regarding Use
Companies sometimes measure the accounts payable turnover ratio by only using the cost of goods sold in the numerator. This is incorrect, since there may be a large amount of administrative expenses that should also be included in the numerator. If a company only uses the cost of goods sold in the numerator, this creates an excessively high turnover ratio. An incorrectly high turnover ratio can also be caused if cash-on-delivery payments made to suppliers are included in the ratio, since these payments are outstanding for zero days.
Norms and Limits
Payment requirements will usually vary from supplier to supplier, depending on its size and financial capabilities. A high ratio means there is a relatively short time between purchase of goods and services and payment for them. Conversely, a lower accounts payable turnover ratio usually signifies that a company is slow in paying its suppliers.
But a high accounts payable turnover ratio is not always in the best interest of a company. Many companies extend the period of credit turnover (i.e. lower accounts payable turnover ratios) getting extra liquidity.
Since the accounts payable turnover ratio indicates how quickly a company pays off its vendors, it is used by supplies and creditors to help decide whether or not to grant credit to a business. As with most liquidity ratios, a higher ratio is almost always more favorable than a lower ratio.
A higher ratio shows suppliers and creditors that the company pays its bills frequently and regularly. It also implies that new vendors will get paid back quickly. A high turnover ratio can be used to negotiate favorable credit terms in the future.
As with all ratios, the accounts payable turnover is specific to different industries. Every industry has a slightly different standard. This ratio is best used to compare similar companies in the same industry.
A Decreasing of Accounts Payable Turnover Ratio
A decreasing turnover ratio indicates that a company is taking longer to pay off its suppliers than in previous periods. The rate at which a company pays its debts could provide an indication of the company’s financial condition. A decreasing ratio could signal that a company is in financial distress. Alternatively, a decreasing ratio could also mean the company has negotiated different payment arrangements with its suppliers.
An Increasing of Accounts Payable Turnover Ratio
When the turnover ratio is increasing, the company is paying off suppliers at a faster rate than in previous periods. An increasing ratio means the company has plenty of cash available to pay off its short-term debt in a timely manner. As a result, an increasing accounts payable turnover ratio could be an indication that the company managing its debts and cash flow effectively.
However, an increasing ratio over a long period could also indicate the company is not reinvesting back into its business, which could result in a lower growth rate and lower earnings for the company in the long term. Ideally, a company wants to generate enough revenue to pay off its accounts payable quickly, but not so quickly the company misses out on opportunities because they could use that money to invest in other endeavors.
Why A High Accounts Payable Turnover Ratio Matters
Because it provides an excellent indicator of short-term liquidity, the accounts payable turnover ratio is a useful tool in establishing creditworthiness. With a high ratio, it’s clear your company is in fine financial condition and making prompt payment for purchases made on credit.
Building a high ratio relies heavily on the credit terms offered by suppliers. However, if your company has the clout to secure better credit terms, your ratio may be lower than usual without necessarily affecting perceived creditworthiness. If you have the opportunity to negotiate optimally favourable payment terms, or take advantage of early payment discounts, go for it—doing so will support a more robust cash flow.
In practice, the true value of a company’s turnover ratio is found in comparison to the company’s industry peers. If (for example) your company’s ratio is 3, but all your competitors have a ratio in the neighbourhood of 5, then it might be time to make some changes.
Limitations of Accounts Payable Turnover Ratio
As with all financial ratios, it’s best to compare the ratio for a company with companies in the same industry. Each sector could have a standard turnover ratio that might be unique to that industry.
A limitation of the ratio could be when a company has a high turnover ratio, which would be considered as a positive development by creditors and investors. If the ratio is so much higher than other companies within the same industry, it could indicate that the company is not investing in its future or using its cash properly.
In other words, a high or low ratio shouldn’t be taken on face value, but instead, lead investors to investigate further as to the reason for the high or low ratio.