In corporate finance, you can add immense value by monitoring and analyzing the accounts payable turnover ratio. The ratio shows short-term liquidity. Transform the payables ratio into days payable outstanding (DPO) to see the results from a different viewpoint.
With the accounts payable ratio analysis, you will gain some insights to improve financial flexibility. Plan to pay your suppliers that offer credit terms at the optimal time. You can respond to changing economic conditions. Improve cash flow management and forecast your business financing needs.
What is the accounts payable turnover ratio, or AP turnover ratio?
The accounts payable turnover ratio is a liquidity ratio that measures how quickly, and frequently, accounts payable turnover occurs within a company. Accounts payable turnover is the number of times a company pays off its vendor debts within a certain timeframe. Similar to most liquidity ratios, a high accounts payable turnover ratio is more desirable than a low AP turnover ratio because it indicates that a company quickly pays its debts.
The AP turnover ratio is one of the best financial ratios for assessing a company’s ability to pay its trade credit accounts at the optimal point in time and manage cash flow.
How do you calculate AP turnover?
Our suggested accounts payable turnover ratio formula is:
Total net credit purchases from all suppliers during the period
Average accounts payable balance for the period
Choose one or more periods of time. To keep on top of AP turnover often, select one month. Or choose each quarter and fiscal year.
Your company’s accounts payable software can automatically generate reports with total credit purchases for all suppliers during your selected period of time. If it’s not automated, you can create either standard or custom reports on demand. Net credit purchases are total credit purchases reduced by the amount of returned items initially purchased on credit. Remember to use credit purchases, not total supplier purchases which would include items not purchased on credit. Some companies use the cost of goods sold (COGS) from the income statement in the numerator instead.
How do you calculate average accounts payable? Look at the balance sheet in your financial statements. Find the accounts payable balance in the current liabilities section. Add the beginning and ending accounts payable balances for the period and divide by two.
(Beginning accounts payable balance + Ending accounts payable balance) / 2
Total credit purchases for year 2019: $1,250,000
Accounts payable balance January 1, 2019: $208,000
Accounts payable balance December 31, 2019: $224,000
Average accounts payable = ($208,000 + $224,000) / 2 = $216,000
AP turnover ratio = $1,250,000 / $216,000 = 5.8 times per year
Instead, the accounts payable turnover ratio is sometimes computed using the total cost of goods sold (COGS) from the income statement divided by the average accounts payable balance for the accounting period. We don’t think that this approach is comprehensive enough to get a handle on cash flow. Therefore, we suggest using all credit purchases in the formula, not just inventory and cost of sales that focus on inventory turnover.
How do you convert the AP turnover ratio to number of days outstanding in accounts payable?
After you’ve computed the payables turnover ratio, you can easily transform the results into days payable outstanding (DPO). The average number of days payable outstanding is calculated as:
Period of time:
One-year formula: 365 days / AP turnover ratio = Days payable outstanding
One-quarter formula: 90 days / AP turnover ratio = Days payable outstanding
One-month formula: 30 days / AP turnover ratio = Days payable outstanding
Converting the AP turnover ratio from the example used above:
365 / 5.8 = 63 Days payable outstanding
Companies may use 360 days instead of 365 days. It’s your choice. Compute AP turnover days often as an accounts payable management tool. Always compute it at year-end for an end of the period stat.
How can you analyze your accounts payable turnover ratio?
After you calculate the accounts payable turnover ratio and DPO, how can you perform financial analysis on the results to gain insights and take action?
Is a higher accounts payable turnover ratio better? A high ratio for AP turnover means that your company has adequate cash and financing to pay its bills. It’s in good financial condition. But your goal isn’t to earn the highest ratio score among your competitors. Some better questions are:
How do you improve accounts payable turnover?
When is the best time to pay your vendors?
First, look at the AP turnover ratio compared to invoice payment terms from your creditors. Are you taking early payment discounts when it makes financial sense? Are you paying invoices too fast when terms are net 30 or net 60 or net 90 days? If you pay invoices quicker than necessary, you’re either paying short term loan interest or not earning interest income as long as you can on your cash balances. Have you thought about stretching accounts payables and condensing the time it takes to collect accounts receivable? You can try this approach. If you do, you want to be sure that your business treats vendors reasonably well. Vendors will cut off your product shipments when your company takes too long to pay monthly statements or invoices.
The 63 Days payables turnover calculation in this article is reasonable on the surface when you think about general creditor terms. You need to make more comparisons to be sure it’s the right number for your company.
Compare the creditor’s turnover ratio to the accounts receivable turnover ratio. If you want to, you can compute an accounts receivable turnover to accounts payable turnover ratio. Are you paying your bills faster than you’re collecting invoices from customer sales? If so, your banker is getting the benefit of earning interest on bigger lines of credit to your company.
Benchmark your AP turnover ratio with industry average stats. What is the average payable turnover or Days payable outstanding? Are your numbers in line?
Compute the accounts payable turnover ratio over time. Use graphs to view the changes in trends as the economy and your business changes.
What is a good accounts payable turnover ratio in days?
The accounts payable turnover in days is also known as days payable outstanding (DPO). It’s a different view of the accounts payable turnover ratio formula, based on the average number of days in the turnover period.
The number for good accounts payable turnover days (and good accounts payable turnover ratio) depends to some extent on your business and benchmarking with your industry average as a comparison. Graphing the trend line over time will alert you to a break from your typical business pattern. Corporate finance should perform a financial analysis that’s broader than an accounts payable analysis to investigate outliers from the trend.
Some people think that, generally, a high turnover ratio is better. If the AP turnover ratio is 7 instead of 5.8 from our example, then DPO drops from 63 to 52. A high turnover ratio implies that lower accounts payable turnover in days is better. The reasoning may be that businesses with a high ratio for AP turnover have sufficient cash flow and liquidity to pay their suppliers reasonably on time. They’re able to take advantage of early payment discounts offered by their vendors when there’s cost-benefit. Possibly they can negotiate even more types of discounts from happy suppliers.
Of course, the DPO should reasonably relate to average credit payment terms stated in the number of days until the payment is due and any discount rate offered for early payment.
For example, one of the credit payment terms offered by suppliers is 2/10 net 30, which means that the supplier will offer a 2% early payment discount if you pay the invoice in 10 days instead of 30 days when the full amount of the invoice is due. If your business has cash availability or can make a draw on its line of credit financing at a reasonable interest rate, then taking advantage of early payment discounts makes a lot of sense. When you receive an early payment discount, you lower the average of payables turnover days.
To balance cash inflows and outflows, compare your accounts payable turnover ratio with your accounts receivable turnover ratio. Or apply the calculation comparing the payables turnover in days to the receivables turnover in days if that’s easier for you to understand.
Another way to put DPO into perspective is to compare AP turnover days to inventory turnover days or compare the accounts payable turnover ratio to the inventory turnover ratio. The cash conversion cycle spans the time in days from purchasing goods to selling them and then collecting the accounts receivable from customers. The longer it takes to sell inventory, the more cash that’s tied up for that length of time. The harder to pay accounts payable because cash flow is slowing down. If the cash conversion cycle lengthens, then stretch payables to the extent possible by delaying payments to vendors. But be reasonable in any delays. Vendors need to be reasonably happy, so they don’t cut off your shipments.
How can you improve your accounts payable turnover ratio in days?
Use a payables automation app seamlessly integrated with your preferred accounting software system.
The app is designed to help you optimize the accounts payable turnover ratio and days. Look for automated accounts payable processing with self-service supplier onboarding, electronic document matching, easy and timely payment approvals, and mass batch payments to suppliers (in addition to bill pay).
Track trends in the ratios.
Dashboards and reports help you automatically track.
Balance the cash inflows and outflows by comparing results to accounts receivable turnover days and inventory turnover ratio days.
Compare your average payables turnover in days to best practices benchmarks for competitors in your industry.
Motivate the sales department and add marketing initiatives to increase the revenue level, turning over inventory more rapidly.
Increase accounts receivable collection efforts for faster cash flow and better working capital management.
Quicker AR collection will help you generate cash to make AP invoice payments to suppliers on a more timely basis.
Experiment to find the optimal number of days outstanding for your business.
To the extent you can while keeping vendors off your back, stretch accounts payable payments and speed up accounts receivable collection.
Use the app software to automatically notify vendors when you plan to pay their invoices and when payments happen. A supplier management feature saves your accounts payable staff from constant vendor follow-up time. It reduces the need to hire additional workers, letting you reduce your hiring budget.
When economic shifts affect global markets, customer total purchases demand and sales can weaken quickly. Will your customers panic and take longer to pay their accounts receivable balances? A significant change in both the accounts receivable turnover ratio and the accounts payable turnover ratio will get your attention quickly. Run an accounts receivable aging report even before the end of the accounting period. Work on collecting customer credit accounts. And decide if you’re paying your bills too quickly.
Using the AP turnover ratio is one of the essentials for better business management.