Accounts Payable Turnover Ratio

What is the Accounts Payable Turnover Ratio?

The accounts payable turnover ratio is a financial metric that calculates the rate of paying off the supplier by the company. It is also sometimes referred to as the Creditors Turnover Ratio or Creditors Velocity Ratio. 

The company calculates the ratio over a period of time, which could be monthly, quarterly, or annually. Then, it determines the frequency of payments made by the company to its creditors. 

Account Payable Turnover Ratio falls under the category of Liquidity Ratios as cash payments to creditors affect the liquid assets of an organization. It, therefore, measures short-term financial liquidity.

It also measures the operating efficiency in terms of placing orders, verifying invoices, checking inventory, making payments, and taking into account the working capital management of the business for meeting current and future needs. 

A good AP Turnover Ratio also takes care of vendor relationships. It focuses on identifying strategic opportunities, giving the company a competitive edge through sourcing quality material at the lowest cost.

What are Accounts Payable (AP)?

Accounts Payable refers to those accounts against which the organization has purchased goods and services on credit.  

Accounts payable also include trade payables and are sometimes used interchangeably to represent short-term debts that a company owes. These are short-term liabilities, i.e., are payable within 12 months from the date the credit is due.

Thus, they fall under 'Current Liabilities.' AP also refers to the Accounts Payable department set up separately to handle the payable process.

The balance of the AP varies throughout the year as the difference between the opening balance and the closing balance of the AP in the balance sheet gets recorded in the Cash Flow Statement under 'Cash Flow from Operating Activities.'

The volume of the transactions handled by the company determines the AP process to be followed within an organization.

A business with low volume transactions will opt for the basic AP Process. Although streamlining the process helps significantly for the company to improve its cash flow.

Accounts Payable Turnover Ratio Formula

Accounts Payable Turnover Ratio is 'net credit purchases' divided by 'average accounts payable balance.' 

The net credit purchases include all goods and services purchased by the company on credit minus the purchase returns. 

The average accounts payable is the average opening and closing balances. 

To better understand the formula, let us look at the illustration below. The formula for is as follows: 

Accounts Payable Turnover Ratio = Net Credit Purchases/ Average Accounts Payable

Where,

• Net Credit Purchases = Total Purchases - (Cash Purchases + Purchase Returns)
• Average Accounts Payable = (Opening Balance of AP + Closing Balance of AP) / 2

Example of Accounts Payable Turnover Ratio

Let's take a few examples for the calculation of the ratio.

For the first example, we'll take a look at the question provided below:

Question: Following is the data of two Companies, PQR and XYZ, for calculating the AP Turnover Ratio.

Solution:

For Company PQR:

Accounts Payable Turnover Ratio  = [($3,500,000 - $1,500,000) - $30,000]/ [($450,000 + $230,000)]/ 2

= $1,970,000/ $340,000 = 5.794 times

Accounts Payable Turnover Ratio (in days) = 365/ 5.794 = 63 days (approx.)

For Company XYZ:

Accounts Payable Turnover Ratio = [($4,450,000 - $2,500,000) - $45,000]/ [($780,000 + $150,000)]/ 2

=$2,905,000/ $465,000 = 6.247 times

Accounts Payable Turnover Ratio (in days) = 365/ 6.247 = 58 days (approx.)

In conclusion:

Let’s interpret AP Turnover Ratio for the above example.

Now that we have calculated the ratio (‘in times’ and ‘in days’) annually, we will interpret the numbers to understand more about the company’s short-term debt repayment process.

The above table is interpreted as follows: 

Company PQR paid 5.794 times to its vendors in a year on average, and Company XYZ paid 6.247 times in a year. 

We can see that Company XYZ has a higher ratio to Company PQR, which suggests that company XYZ is more frequently paying off its debts.

The average number of days taken for Company XYZ is 58 days, whereas, for Company PQR, it is 63 days, indicating faster processing and a higher frequency of payments.

However, to determine whether the company is efficient or effective in paying those debts, several factors are overseen before arriving at a conclusion, rather than interpreting the numbers straight off the face value.

Understanding Accounts Payable Turnover Ratio

A better understanding of the accounts payable turnover ratio helps the organization prioritize operations in tune with the organizational goals.  

It is a relative measure and guides the organization to the path where it wants to grow and maximize its profit. On the other hand, a ratio far from its standard gives a different picture to all the stakeholders.

A good understanding of one’s accounts payable turnover ratio can help an organization look into redundant areas of operations where optimization can maximize profits. 

A ratio is a helpful gauge to ascertain the quality of partnerships an organization enters. A better ratio always attracts the best suppliers. 

It provides them with better quality material, and ultimately the end products are of quality.

A good accounts payable turnover ratio also helps the investors understand the company’s creditworthiness and helps in making long-term investment decisions.

The shareholders can count on their returns if the company ever wounds up. It also instills trust that better management practices or corporate governance will take the company forward in the foreseeable future.

Let us look at ‘What is an ideal ratio for an organization?’ and What does a low or high ratio indicate?’ to further understand.

Ideal Account payable Turnover Ratio

Ideally, a higher account payable turnover ratio is said to be ideal. However, the factors listed above play a crucial role in determining the optimal turnover ratio for the said business. 

Every industry has its own cash flow constraints, sales, or inventory turnover. Comparing account payable turnover ratio from two different trades makes no sense as it varies from industry to industry.

Like all ratios, looking at only at account payable turnover ratio will not assist an investor or any other shareholder judge a company’s debt repayment efficiency.

A lot of parameters play a role in determining the ideal ratio. 

A business in the service industry will have a different account payable turnover ratio than a business in the manufacturing industry. A lot of factors will play a role in determining that ratio.

Hence, organizations should strive to attain a ratio that takes all pertinent factors into account. Establishing an ideal benchmark for the ideal turnover ratio, specific to their own business, can significantly enhance the efficiency of their accounts payable processes.

What does a higher AP ratio indicate?

A higher AP ratio represents the organization’s financial strength in terms of liquidity. It also determines the creditworthiness and efficiency in paying off its debts. The vendors or suppliers are attracted to an organization with a good credit rating.

As a result, better credit arrangements exist for the company, which helps the organization manage its cash flows and debts more efficiently.

However, a high ratio also indicates the company is not reinvesting the idle or excess cash back into the business.

What does a low AP ratio indicate?

A low AP turnover ratio usually indicates that the company is sluggish while paying debts to its creditors. A low ratio can also point toward financial constraints in terms of tight liquidity and cash flow constraints for the organization.

However, sometimes organizations may fix flexible terms with their creditors to enjoy extended credit limits. This extended credit limit helps the organization better manage its working capital. 

Accounts Payable Turnover Ratio Vs. Accounts Receivable Turnover Ratio

Accounts Payable Turnover Ratio and Accounts Receivable Turnover Ratio are two sides of the same coin. 

Let us look at the table below to better differentiate between them:

Factors affecting the AP Turnover Ratio

An Accounts Payable Turnover Ratio is not only influenced by the standards existing within an industry but also depends on several other factors: 

1. The supplier’s terms and conditions.
2. The industry standards ratio.
3. Accounts Receivable Turnover Ratio (ARTR)
4. Inventory Turnover Ratio (ITR)
5. The interest rate on the amount earned on short-term balances.
6. The creditworthiness of the organization

1. The supplier terms and conditions 

While taking goods on credit, the supplier usually offers a credit period of 30-60 or 90-days (also depends largely on the industry). This credit period gives the organization flexibility in managing working capital and provides an incentive to earn interest for the period the cash is ideal.

The organization can further monitor payments and optimize its payables to earn maximum interest and minimize late payment charges or penalties.

2. The industry standard ratio

As businesses operate in different industries, it is advisable to check the standard ratio of the particular industry in which an organization operates. 

An organization should strive to achieve the accounts payable turnover ratio nearer to the industry standards as different norms and credit limits exist in a particular industry. For example, suppliers usually offer a prolonged credit period in the jewelry business. 

3. Accounts Receivable Turnover Ratio

Accounts Receivable Turnover Ratio calculates the cash inflows in terms of its customers paying their debts arising from credit sales. Therefore, the ability of the organization to collect its debts from customers affects the cash available to pay debts of its own.

4. Inventory Turnover Ratio

A higher inventory ratio indicates that the company can sell the goods quickly in the market, which suggests a strong demand for a product. It also implies that the production department can restore inventory quickly.

Restoring inventory leads to placing more orders with the suppliers, and with more credit purchases and payables, accounts payable turnover ratio gets affected. 

5. The interest rate on ideal cash

When a creditor offers a prolonged credit period, the organization has enough time to repay its debts. The excess funds are parked in short-term financial instruments to earn short-term interest.

These short-term financial instruments are generally marketable securities like shares, bonds, and money market funds which can liquidate at a moment’s notice. The average interest varies from 0.5% to 1.5%. This supplementary interest income acts as an additional source of revenue for the organization.

6. The creditworthiness of the organization

A company with a good credit rating is alluring to the suppliers. They are more likely to do business with an organization with good creditworthiness. This creditworthiness gives the organization an edge to negotiate credit periods and enjoy flexibility in payments, ultimately affecting the ratio.

In conclusion, there are several factors one should see before comprehending the numbers of the accounts payable turnover ratio. A proper diagnosis can help an organization adopt better business practices to improve creditworthiness and cash flow.

The investors can better assess the liquidity or financial constraint of the company to pay its dues, which in turn would affect their earnings. The shareholders can assess the company better for its growth by analyzing the amount reinvested in the business. 

Accounts Payable Turnover Ratio Limitations

After having understood the AP turnover ratio and its dependency on various factors (both internal and external).

First, let us move on to the limitations that the ratio presents:

1. While some organizations calculate the ratio using ‘net credit purchases’; some use ‘cost of goods sold’ as the numerator. This interchangeability gives an inaccurate figure as the ‘cost of goods sold’ also includes administrative expenses, resulting in an inflated ratio. 
2. Organizations sometimes also use ‘total purchases’ as a numerator which includes a substantial part of cash purchases. Unfortunately, this cash inclusion gives us an inaccurate accounting figure, as only debt purchases represent the account’s payables.
3. A lower ratio could indicate multiple things on both sides of the spectrum. For example, one side may show that the company is experiencing financial instability. In contrast, the other side could mean that the company is reinvesting its excess cash into the business resulting in a lower ratio.
4. A higher ratio is ideal because it points to the timely payments made by the company. However, a ratio higher than the industry standards may indicate that the company is not reinvesting its excess cash into the business. 

In conclusion, it is best to consider the factors responsible for the said ratio before deriving an inference. 

How to improve Accounts Payable Turnover Ratio

Improving the Accounts Payable Turnover Ratio can strengthen the creditworthiness of an organization, giving it more power to buy more goods and services on credit. 

Let us look at some of the ways to optimize the accounts payable and for improving the Accounts Payable Turnover Ratio:

1. Automating the accounts payable helps reduce cost and enriches vendor relationships for faster and more secure invoice processing. It also reduces errors and delays and helps capture early discounts offered by the supplier. 
2. Increasing the efforts of the accounts receivable department for faster collection of payments from the customer, and therefore ensuring better working capital availability.
3. Incentivize the production department for better utilization of the inventory. This turnover would result in the reduction of the cost involved in the idle stock.
4. Track the process of invoice input and authorizations. Look for discrepancies that could lead to error or fraud, as this will help in optimizing the AP process and ensure timely payments. 
5. A proper communication channel between the organization and vendor can help free ambiguity. 

Researched and authored by Samridhi Singh | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Retained Earnings
• Fraud Triangle
• Cost of Goods Manufactured (COGM)
• Marginal Cost Formula
• Non-Current Assets