A high accounts payable ratio signals that a company is paying its creditors and suppliers quickly, while a low ratio suggests the business is slower in paying its bills. This is a critical metric to track because if a company’s accounts payable turnover ratio declines from one accounting period to another, it could signal trouble and result in lower lines of credit.
Conversely, funders and creditors seeing a steady or rising AP ratio may increase the company’s line of credit.
What is Accounts Payable (AP) Turnover Ratio?
The accounts payable turnover ratio measures how quickly a business makes payments to creditors and suppliers that extend lines of credit. Accounting professionals quantify the ratio by calculating the average number of times the company pays its AP balances during a specified time period. On a company’s balance sheet, the accounts payable turnover ratio is a key indicator of its liquidity and how it is managing cash flow.
Key Takeaways on Accounts Payable (AP) Turnover Ratio
- A higher accounts payable ratio indicates that a company pays its bills in a shorter amount of time than those with a lower ratio.
- Low AP ratios could signal that a company is struggling to pay its bills, but that is not always the case. It could be using its cash strategically.
- Businesses that rely on lines of credit typically benefit from a higher ratio because suppliers and lenders use this metric to gauge the risk they are taking.
How to Calculate Accounts Payable (AP) Turnover Ratio
Accounting professionals calculate accounts payable turnover ratios by dividing a business’ total purchases by its average accounts payable balance during the same period.
Accounts Payable (AP) Turnover Ratio Formula & Calculation
Accounts payable turnover rates are typically calculated by measuring the average number of days that an amount due to a creditor remains unpaid. Dividing that average number by 365 yields the accounts payable turnover ratio.
Average number of days / 365 = Accounts Payable Turnover Ratio
Breaking Accounts Payable Turnover into Days
Use this formula to convert AP payable turnover to days.
Accounts Payable Turnover Ratio in Days = 365 / Payable turnover ratio
How can you analyse your accounts payable turnover ratio?
To see how your company is trending, compare your AP turnover ratio to previous accounting periods. To see how attractive you will be to funders, match your AP ratio to peers in your industry.
What is a good accounts payable turnover ratio?
Generally, a high AP ratio indicates that you satisfy your accounts payable obligations more quickly.
Do you want a higher or lower accounts payable turnover?
It depends. If your business relies on maintaining a line of credit, lenders will provide more favourable terms with a higher ratio. But if the ratio is too high, some analysts might question whether your company is using its cash flow in the most strategic manner for business growth.
Accounts Payable (AR) Turnover Ratio Example
Say that in a one-year time period, your company has made $25 million in purchases and finishes the year with an open accounts payable balance of $4 million.
$25 million / $4 million = 6.25
That means the company has paid its average accounts payable balance 6.25 times during that time period.
Increasing Accounts Payable Turnover Ratio
Creditors and investors will look at the accounts payable turnover ratio on a company’s balance sheet to determine whether the business is in good standing with its creditors and suppliers. Higher figures indicate that a company pays its bills on a more timely basis, and thereby has less debt on the books.
While that might please those stakeholders, there is a counterargument that some businesses may be better off deploying that cash elsewhere, with an eye toward growth.
Decreasing Accounts Payable Turnover Ratio
Lower accounts payable turnover ratios could signal to investors and creditors that the business may not have performed as well during a given timeframe, based on comparable periods.
Tracking Payables Turnover Ratio
While businesses may have strategic reasons for maintaining lower accounts payables turnover ratios than cash on hand would show is necessary, there are other variables. Companies could have low turnover ratios due to favourable credit terms. Similarly, they might have higher ratios because suppliers demanded payment upon delivery of goods or services. Some companies may spend more during peak seasons, and likewise may have higher influxes of cash at certain times of the year.
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AP Turnover vs. AR Turnover Ratios
Accounts payable turnover provides a picture of a company’s creditworthiness, while accounts receivable turnover ratios measure how effective is at collecting revenues owed to it. A high accounts receivable turnover ratio indicates a company is effectively collecting what it’s owed, whereas a low ratio signals a company is struggling in its collection process or is extending credit to the wrong customers.
Tracking Your Accounts Payable Turnover
Businesses can track their accounts payable turnover ratios during each accounting period without having to gather additional information. Using the abovementioned formulas, here is an example of how to calculate your accounts payable turnover ratio. Simply take the sum of your net AP during a given accounting period and divide it by the average AP for that period.
Net AP / Average AP = Accounts Payable Turnover Ratio
In order to determine the amounts that you need to divide:
- Net AP: Subtract all credits (such as inventory returned to suppliers) from gross AP incurred.
- Average AP: Add your AP balances at the beginning and end of the accounting period and divide the sum by 2.
During FY 2020, a company’s total AP for funds owed to creditors and suppliers was $1 million. However, the company received credits for adjustments and returned inventory amounting to $100,000. After subtracting the $100,000 in credits from the $1 million in gross AP, the net AP equals $900,000.
The company had a total AP balance of $80,000 in Jan 1, 2020 and ends the year on Dec. 31, 2019 with outstanding AP of $120,000. Taking the $200,000 total, dividing it by 2 gives an average AP of $100,000. After dividing the net AP of $900,000 by $100,000, the company’s accounts payable turnover ratio was 9.0
Net AP: $1,000,000 -$100,000 = $900,000
Average AP: $80,000 + $120,000 = $200,000 / 2
= Accounts Payable Turnover Ratio: 9.0
Importance of Your Accounts Payable Turnover Ratio
Executive management should pay close attention to the company’s accounts payable turnover ratio. Investors and any suppliers poised to extend credit will look at it closely. It can have an impact on cost of goods sold, as suppliers may use that ratio to determine financing terms—and that can affect the bottom line.
Limitations of the Accounts Payables Turnover Ratio
While creditors will view a higher accounts payable turnover ratio positively, there are caveats. If a company has a higher ratio during an accounting period than its peers in any given industry, it could be a red flag that it is not managing cash flow as well as the industry average. If a company does not believe this is the case, finance leaders may wish to have an explanation on hand.
4 Tips to Improve Your Accounts Payable (AP) Turnover Ratio
- Audit how your organisation is managing its cash flow, and determine what impact reducing days payable outstanding might have
- Evaluate your accounts receivable turnover ratio and determine if delays in collections are having an impact on your ability to cover expenses.
- Determine if you can improve your line of credit terms with suppliers.
- Measure the cost of goods sold, and determine if there’s room for improvement.