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.
- 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. The AP Turnover Ratio measures the frequency with which a business settles its debts to suppliers within a defined timeframe.
Follow these instructions to compute it:
- Total Cost of Sales (or Total Purchases): This value represents the aggregate expense for goods sold over a specific timeframe. Generally, this data is located on the company's profit and loss statement. In cases where the expenses from sales data is inaccessible, total acquisitions may be used as a substitute, although this data may not always be available in public financial documents.
- Average Accounts Payable: This value corresponds to the average amount that the company is in debt to its suppliers, stemming from goods and services it acquired on credit. The calculation is as follows: (Accounts Payable at Start of Period + Accounts Payable at End of Period) / 2. These data points can be sourced from the company's balance sheet.
Once you have these values, divide the total expenses from sales (or total acquisitions) by the average accounts payable to get the AP Turnover Ratio.
The figure you obtain represents the frequency with which the company has settled its typical payable amount within the specified period. For instance, if the AP turnover ratio is 5, it signifies that the company has settled its debts to its suppliers 5 times throughout the duration of the period.
Ensure consistency in periods for this calculation. If you utilize a year's worth of expenses from sales, you should also use the accounts payable from the start and end of the same year.
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
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.
- Talk to suppliers about payment terms: If they can give you more time for payments, this will lower your turnover ratio since you'll be making payments less often.
- Use credit wisely: Using credit can help you space out vendor payments. However, increased interest charges can hurt your bottom line and over-used credit can damage your credit score.
- Watch inventory closely: If you manage inventory well, you might be able to make fewer or smaller orders. Less ordering means fewer payments to suppliers.
- Don’t pay invoices early: Hold onto your cash until the payment deadline.
- Use AP technology: Tools can help automate payment processes, schedule payments, and negotiate better terms with suppliers.
While it's sometimes helpful to slow down payments to improve your cash flow, you don't want to slow them down too much. Paying too slowly might suggest you're having cash flow problems, or that you're not managing your debts well. As with most things, balance is key.
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 favorable 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.
Overall, tracking your AP turnover ratio offers insights into short-term liquidity and how efficiently the organization is managing its payables. Here are a few best practices to tracking AP turnover:
- Calculate the AP turnover ratio for the periods you’re measuring.
- Record the ratios in a way that will let you easily come back and compare different time periods.
- Use the ratios from these different time periods to determine what the trends are.
- Compare ratios to industry norms or specific competitors and account for seasonality and other factors that affect your AP turnover ratio over time.
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.
While both ratios provide insights into a company's cash flow, they focus on different aspects. AP Turnover Ratio looks at how well a company manages its payments to suppliers, while AR Turnover Ratio gauges the effectiveness of a company's credit and collection policies. Both should be evaluated in the context of a company's overall financial performance, industry norms, and strategic cash management objectives.
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. The Accounts Payable (AP) Turnover Ratio is an important metric for businesses as it provides insights into the company's short-term liquidity position and its relationship with suppliers.
The Accounts Payable (AP) Turnover Ratio is a crucial financial figure for businesses, as it offers insights into a company's financial health and vendor relationships. Here's why it's significant:
- Managing Cash Flow: The AP Turnover Ratio provides a snapshot of your company's cash flow management. If the ratio is on the higher side, your business might be settling its bills quite promptly, which could be putting a strain on your cash reserves. On the other hand, a lower ratio could suggest your firm is maintaining its cash for extended periods, which can be beneficial for cash flow, but it may indicate potential cash flow issues if it's extremely low.
- Vendor Relations: Your payment speed can influence your rapport with suppliers. Swift payments (indicated by a high AP Turnover Ratio) could nurture trust and potentially result in more favorable future terms. Conversely, consistently delayed payments (a low AP Turnover Ratio) might harm relationships and possibly result in less accommodating credit terms or supply interruptions.
- Liquidity Status: The AP Turnover Ratio can also shed light on your company's liquidity status. A higher ratio might suggest robust liquidity, although it could also mean your business might not be capitalizing on the credit terms provided by suppliers. A lower ratio could indicate weaker liquidity, or it might show your firm is strategically managing its cash by utilizing the full extent of supplier credit terms.
- Benchmarking: By comparing your AP Turnover Ratio with other businesses within your sector, you can gain insights into industry standards and how your payables management stacks up against competitors.
- Financial Risk Assessment: A very low AP Turnover Ratio could potentially raise concerns for investors and lenders, as it could suggest financial instability or inefficient cash management.
While the AP Turnover Ratio is a valuable tool, it only provides a portion of the financial picture. For a well-rounded view of a company's financial stability, it should be considered alongside other financial ratios and metrics.
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.
While the Accounts Payable (AP) Turnover Ratio can provide some good insights into a company's financial health, it's not perfect. There are a few limitations you should keep in mind:
- Different Accounting Styles: Companies don't all keep their books the same way. Some might use cost of sales in their calculation, while others might use total purchases. This means it can be pretty tough to compare ratios across different companies because they're not all playing by the same rules.
- Missing the Full Story: The AP Turnover Ratio doesn't tell you everything. For instance, a high turnover ratio might suggest that a company is paying its suppliers really quickly, which sounds great, right? But it could also mean that the company isn't fully using the credit terms its suppliers offer, which could actually be hurting its cash flow.
- Different Strokes for Different Folks: Every industry is a bit different. They have different payment cycles, different credit terms, all that jazz. So, what might look like a fantastic AP Turnover Ratio in one industry might not be so hot in another one. Always best to compare this ratio with the industry standards.
- Seasonal Shifts: A lot of businesses see their sales go up and down depending on the season. This can really impact the AP Turnover Ratio, so a single calculation at a certain point in time might not give you a clear picture of a company's overall financial health.
- All Suppliers Aren't Equal: The AP Turnover Ratio doesn't take into account the different credit terms a company might have with its suppliers. For example, a company might be paying some suppliers quicker because they offer discounts for early payment, while taking longer to pay others who offer longer payment terms. This ratio doesn't reflect these nuances.
The AP Turnover Ratio offers useful clues about a company's financial situation, it shouldn't be the only financial KPI examined. It's best to look at it alongside other financial metrics and ratios to get a full understanding of a company's financial health.
4 Tips to Improve Your Accounts Payable (AP) Turnover Ratio
Optimizing your Accounts Payable (AP) Turnover Ratio can significantly enhance your business's financial health and supplier relationships. These strategies aim to boost your liquidity, improve supplier rapport, and streamline cash flow management:
- Audit how your organization 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.
Automate Your Accounts Payable Process With NetSuite
NetSuite's Accounts Payable Software is designed to help businesses streamline their operations, boost productivity, and enhance control by automating invoice processing and payment tasks. With this tool, you can drastically cut down on the time and energy needed to process invoices by removing the need for manual entry and automatically applying discounts. In instances where there are discrepancies between invoices and purchase orders, NetSuite smoothly manages exception processing. Plus, it offers real-time visibility into your entire accounts payable workflow, mitigating the risk of misplaced bills or fraudulent invoice payments.
Accounts Payable (AP) Turnover Ratio FAQs
How can you analyze 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 favorable 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.