Effective accounts payable management is essential when it comes to maintaining a favorable working capital position. It’s also an important consideration in the process of building strong supplier relationships.
But in order to improve the way in which accounts payable operates in an organization– and reap the subsequent benefits – you first need a clear understanding of how it currently performs.
This can be achieved by using accounts payable key performance indicators (KPIs). Measuring performance in key facets of accounts payable can provide you with valuable insights that point out what can be done to improve the process.
One such KPI, and a common way of measuring AP performance, is the metric known as the accounts payable turnover ratio.
What is the accounts payable turnover ratio?
When a buyer orders and receives goods and services, but has not yet paid for them, the invoice amount is recorded as a current liability on its balance sheet. These short-term liabilities are known as accounts payable.
The speed with which a business makes payments to the creditors and suppliers that have extended lines of credit and make up accounts payable is known as accounts payable turnover (AP turnover). Accounts payable turnover ratio (AP turnover ratio) is the metric that is used to measure AP turnover across a period of time, and one of several common financial ratios.
In a nutshell, the accounts payable turnover ratio measures how many times a business pays its creditors during a specified time period. This information, represented as a ratio, can be a key indicator of a business’s liquidity and how it is managing cash flow.
A higher AP turnover ratio is generally seen as favorable. The higher the AP turnover ratio, the faster creditors are being paid, and the less debt a business has on its books. As such, the optimum position is one in which an organization pays off its accounts payable in a timely manner, without compromising its ability to invest and reinvest.
Conversely, a low accounts payable turnover is typically regarded as unfavorable, as it indicates that a business might be struggling to pay suppliers on time.
The AP turnover ratio allows creditors and investors to determine whether a company is in good standing with its suppliers, as well as gauging the creditworthiness of the business and the risks that it may be taking.
Accounts receivable turnover ratio is the opposite metric, measuring how effectively a business manages to collect its accounts receivable.
Difference between accounts payable turnover ratio and days payable outstanding (DPO)
Another accounts payable metric, days payable outstanding (DPO) – also known as accounts payable days, or creditor days – shares some similarities with accounts payable turnover ratio.
As its name suggests, DPO measures the time taken for a company to pay its supplier invoices and expresses accounts payable turnover in days. For example, a DPO of 35 means that it takes an average of 35 days to pay suppliers. The formula for calculating DPO is as follows:
DPO = Accounts Payable/Cost of Goods Sold X Number of days
AP turnover ratio and days payable outstanding both measure how quickly bills are paid but using different units of measurement.
Together with days sales outstanding (DSO) and days inventory outstanding (DIO), DPO can also be used to calculate the cash conversion cycle (CCC), which expresses the time taken for a company to convert resources into cash flows from sales.
Accounts payable turnover ratio formula
AP turnover is calculated using the following formula:
Accounts payable turnover ratio = Total supplier credit purchases / (average accounts payable).
In the formula, total supplier credit purchases refers to the amount purchased from suppliers on credit (which should be net of any inventory returned).
Meanwhile, average accounts payable is the combined sum of the opening and closing balances of the accounts payable for the period, divided by two:
Average accounts payable = (Beginning accounts payable + ending accounts payable)/2
How to calculate accounts payable turnover ratio
The AP turnover ratio formula is relatively simple, but an explanation of how it’s used to calculate AP turnover ratio can make the metric even clearer.
AP turnover ratio is worked out by taking the total supplier purchases for the period and dividing this figure by the average accounts payable for the period. To find out the average accounts payable, the opening balance of accounts payable is added to the closing balance of accounts payable, and the result is divided by two.
It can theoretically be calculated for any accounting period, but it’s typically used as a quarterly or annual metric.
Accounts payable turnover example
To further elucidate how the calculation works, using a hypothetical example is helpful:
- A business has total supplier credit purchases for the year of $100 million.
- The opening balance of accounts payable for the year is $30 million.
- The closing balance of accounts payable for the year is $50 million.
The average accounts payable for the entire year is calculated as follows:
- Opening balance ($30 million) + closing balance ($50 million) = $80 million.
- Combined balances ($80 million) / 2 = $40 million.
The accounts payable turnover ratio is then calculated as follows:
- Total supplier credit purchases ($100 million) / average accounts payable ($40 million)
- ($100 million) / ($40 million) = 2.5
So in this example, the accounts payable turnover ratio is 2.5.
Understanding accounts payable turnover ratio
As a measure of short-term liquidity, the AP turnover ratio can be used as a barometer of a company’s financial condition.
A ratio that increases quarter on quarter, or year on year, shows that suppliers are being paid more quickly, which could indicate a cash surplus. As such, a rising AP turnover ratio is likely to be interpreted as the business managing its cash flow effectively and is often seen as an indicator of financial strength in the company.
If the ratio is decreasing over time, on the other hand, this could an indicator that the business is taking longer to pay its suppliers – which could mean that the company is in financial difficulties.
But it’s important to note that while the accounts payable turnover ratio does show how quickly invoices are being paid, it doesn’t show the reasons behind it.
In reality, a rising AP turnover ratio can result from any number of factors, such as simplified workflow practices, increased use of technology and AP automation, speeding up dispute procedures and their resolution, as well as renegotiating payment terms and taking advantage of discounts. On a different note, it might sometimes be an indication that the company is failing to reinvest in the business.
Conversely, while a decreasing turnover ratio might mean the company does not have the financial capacity to pay debts, it could also mean that the company is reinvesting in the business. Other factors such as increased disputes with suppliers, staffing and technical issues could lead to a decreasing AP turnover ratio.