What’s it: The accounts payable turnover ratio is a financial ratio showing the number of times a company pays its suppliers over a year or accounting period. It measures the company’s effectiveness in managing accounts payable.
Accounts payable arise when, at the time the financial statements are prepared, the company has received input from suppliers but has not paid for it. Therefore, the company presents it as a liability in the financial statements.
In general, a low ratio is preferable, but we should also draw conclusions with caution and explore the causes.
Why is the accounts payable turnover ratio important?
The accounts payable turnover ratio is important for several reasons. It depends on who is using this ratio.
First, management can evaluate how they can save cash outflows. For example, they pay suppliers early to get discounts or other waivers from suppliers. So, nominally, less money is spent.
In other cases, management may see suppliers offering lenient credit. Thus, they pay suppliers less frequently. Thus, they are more flexible in managing cash flow, which can be invested in other more urgent needs.
Second, investors examine this ratio to determine whether the company has enough cash to meet its short-term obligations. Otherwise, it could be a signal of liquidity problems within the company.
Third, creditors use this ratio to measure the company’s ability to pay in the short term. Therefore, it is important to decide whether to lend or extend credit to the company.
How to calculate and interpret the accounts payable turnover ratio?
The formula for calculating the ratio is to divide purchases by the average trade payables. Unfortunately, purchase figures are not available in the balance sheet or income statement, so we must calculate them manually. Meanwhile, the average accounts payable (you can see on the balance sheet under current liabilities) is calculated by adding up the current period’s accounts payable with the previous period and dividing the result by 2.
- Accounts payable turnover = Purchases / Average accounts payable
Since it is not explicitly stated in the financial statements, we calculate purchases using the following formula:
- Purchases = Ending inventory – Beginning inventory + Cost of goods sold
Let’s plug the second equation above into the first formula. The results are as follows:
- Accounts payable turnover = (Ending Inventory – Beginning Inventory + Cost of Goods Sold ) / Average accounts payable
- Accounts payable turnover = (Cost of Goods Sold – Change in inventory) / Average accounts payable
Take a simple example. A company totals $20 million in purchases in 2021. The company’s balance sheet presents accounts payable of $4 million in 2020 and $5 million in 2021.
We can input the data into the first equation above. Thus, the results are as follows:
- Average accounts payable = ($4 million + $5 million) / 2 = $4.5 million
- Accounts payable turnover ratio = $20 million /$4.5 million = 4.4
We can see that the average company pays its suppliers approximately 4 times a year from these results. So whether it’s ideal or not, you can then compare the results with industry averages or peer companies.
How to interpret the accounts payable turnover ratio?
Accounts payable consequent cash outflows. The company has to pay its suppliers. So, when it spikes, it’s getting less and less favored because the company has less money.
And, the accounts payable turnover ratio measures how many times a year the company pays all of its suppliers. Therefore, we must interpret it carefully and explore why it is higher or lower.
The higher the accounts payable turnover ratio, the more often the company pays its suppliers. And it’s usually less favorable because the company has less money to hold, especially if it’s because the company doesn’t take full advantage of the credit facilities provided by its suppliers and pays them off too soon.
Or, a high ratio occurs because the supplier’s credit terms are stringent. If alternatives exist and are feasible, management should probably consider switching to another supplier where requirements are more lenient.
However, if the high ratio is due to companies making early payments to get early payment discounts from suppliers, that’s not a problem. Supposedly, a high ratio will not cause cash flow problems; on the contrary, it can save cash out.
In addition, if the company has sufficient cash, a high ratio should not be a problem. Although paying suppliers faster, the company can pay it off.
Meanwhile, if the accounts payable turnover ratio is low, it will take longer to pay its suppliers. That may result from the supplier’s lenient credit and billing policies. And, as long as it is not penalized, it is preferable because the company can use the money for other more urgent purposes. For example, the company can reinvest money into its business to generate more growth and revenue in the future.
However, a low ratio can also indicate a liquidity crisis if the reason is because the company does not have enough cash and short-term investments. Because cash is inadequate, the company has difficulty paying its suppliers. As a result, it is slower to pay suppliers. Thus, a decrease in the ratio can indicate the company is in financial trouble.
Finally, as with other financial ratios, reading the accounts payable turnover ratio should also be compared with peer companies or industry averages, not just comparing them historically. This is because the ideal figure may vary between industries. That will lead us to further investigate the reasons for the high or low ratio.
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