Accounts Payables Turnover Ratio

The Accounts Payables Turnover Ratio is a financial ratio that helps a company determine its liquidity. This ratio represents the time a company takes to pay off its creditors and suppliers. It aids in evaluating a business's capacity for managing its cash flows and repaying trade credit obligations.

The Accounts Payables (AP) Turnover Ratio is crucial for creditors since it helps them assess whether to expand the company's line of credit. Investors may use the ratio to determine if a company has adequate cash to pay off its short-term financial obligations.

The accounts payables turnover ratio indicates how swiftly a company may repay funds to its vendors and creditors. It is a significant financial and efficiency metric used to assess a business's ability to manage its cash flows and pay its trade credit obligations. Accounts payable can be identified as a liability in the general ledger that indicates a company's short-term credit for products or services acquired from outside sources. 

A declining turnover ratio over time indicates that the business is paying its suppliers slowly, which may be a sign of deteriorating financial health. If the business pays its suppliers on time, it may indicate that the suppliers are requesting quick payments or that the business is taking advantage of early payment incentives provided by vendors.

The Accounts Payables Turnover Ratio formula is as follows: 

AP turnover ratio = Net Credit Purchases / Average Accounts Payable

The average accounts payable is the amount of accounts payable at the start and end of an accounting period, divided by two.

In certain instances, the numerator includes the cost of goods sold (COGS) instead of net credit purchases. 

Let us go through the following examples to understand the ratio:

Example #1

​​Suppose a company named Annex Ltd. recorded $150,000 in annual purchases on credit and $30,000 in returns in the year ended December 31, 2020. At the start and end of the year, accounts payable were $40,000 and $20,000, respectively. Annex Ltd. wanted to calculate the frequency with which it paid its debts during the fiscal year. 

According to the  Accounts Payables Turnover Ratio formula:

AP turnover ratio = Net Credit Purchases / Average Accounts Payable

= 150,000 - 30,000 / 40,000 + 20,000)/2

= 120,000 / 30,000

= 4

Thus, we can see that the company's accounts payable turned over four times in the fiscal year. 

Example #2

Let us assume that two companies operate in the same industry. The companies are named Rose Cosmetics and Panache Beauty. Rose Cosmetics wanted to compare its AP turnover ratio with that of Panache Beauty’s. In the fiscal year 2022-23, Rose Beauty recorded an AP Turnover Ratio of 5, whereas Panache Beauty reported a ratio of 3. This implies that Rose Cosmetics paid its suppliers at a faster rate than Panache Beauty and has been managing its cash flow more efficiently. This is an example of the AP Turnover Ratio.

Investors can study the ratio to see how frequently a company pays its accounts payable. This ratio represents the speed at which a business pays back its suppliers.

When the AP turnover ratio is measured over time, a declining value means that a business is paying its suppliers later than it was in the past. This can indicate that a business is having financial difficulties. On the other hand, a declining percentage can also indicate that the business and its suppliers have worked out different terms for payment.

An increase in the AP turnover ratio indicates that the company is making payments to its suppliers faster than in the past and that the business has adequate cash to pay its current obligations on time. It may suggest that the business is efficiently managing its cash flow and debts. On the other hand, an increasing ratio over an extended duration suggests that the business is not investing capital for its operations. In the long run, this may lead to a decline in the company's growth rate and earnings.

The methods for increasing the AP turnover ratio are as follows:

• Paying invoices from vendors by the specified date.
• Paying invoices substantially sooner to take advantage of early payment reductions.
• Enhancing the sales turnover rate and revenue from sales.
• Speeding the collection of accounts receivable to create cash flow and pay invoices on time.
• When necessary, employing the company's line of credit to fill in funding gaps.
• Considering customer invoice factoring to increase cash flow by collecting payments earlier.

The methods for lowering the AP turnover ratio include the following:

• Establishing and adopting a corporate policy extending the days for accounts payable turnover.
• Extending the accounts payable payment period without jeopardizing vendor relations
• Reducing the frequency of early payment discounts on bills.

The accounts payables turnover ratio offers assumptions for calculating payables balances and supplier payment cash flows in financial models that forecast future performance.

Analysts can predict turnover rates by analyzing past performance and the projected efficiency increases from changes to the payables process. The expected ratio, when combined with sales projections, aids in estimating future payables balances and supplier payments.

The importance of this ratio has been discussed below:

• The AP Turnover Ratio offers an overview of the business's cash flow management. If the ratio is higher than average, the company may be paying its invoices quickly, straining the cash flow. At the same time, a lower ratio may suggest that the business is holding onto its cash for a longer duration, which is suitable for cash flow. However, if it is deficient, there are possible cash flow concerns.
• The AP turnover ratio can reveal a business's liquidity. A greater ratio may indicate strong liquidity, but it may also indicate that the organization is not taking advantage of suppliers' credit conditions.
• Comparing the AP Turnover Ratio to other companies in the same industry will help investors understand the industry standards and the competitors.

An organization's AP turnover ratio may be compared to that of organizations in the same industry. This might aid investors in evaluating a company's ability to pay its bills in comparison to others. However, a constantly high or rising ratio, particularly in relation to the industry average, may inform creditors and investors that a business is mismanaging its cash and is not investing in its expansion. As a result, investors should not accept a high or low ratio at face value. Instead, investors who see the AP turnover ratio might wish to look into the cause of it further.

The difference between the two ratios is as follows:

Accounts Payables Turnover Ratio

• ​​The AP turnover ratio measures the time a business takes to pay off its debts and obligations. 
• The AP turnover ratio is a liquidity indicator that shows a business's ability to settle its financial obligations.
• The formula for determining the AP turnover ratio comprises net credit purchases and average accounts payable.

Accounts Receivable Turnover Ratio

• The AR turnover ratio indicates how efficiently a business can collect receivables. A higher AR ratio indicates that the business can collect cash promptly.
• The AR turnover is a ratio of efficiency that assesses how effectively a company employs its liabilities and assets to earn revenue.
• The AR turnover ratio formula includes net credit sales and average accounts receivable.