The objective of a business should be to generate enough revenue to pay off its accounts payable as quickly as possible, but not so quickly that it loses opportunities by not using that money to invest in other businesses.
The accounts payable turnover ratio is a helpful activity ratio for learning more about a company's financial situation.
What is the Accounts Payable Turnover Ratio?
The accounts payable turnover ratio, also known as the 'creditors turnover ratio', measures the number of times a company pays off its creditors in a year. Accounts payable turnover gauges at which rate a company pays its suppliers.
Accounts payable are short-term debts owed to suppliers and creditors by a business.
The accounts payable ratio is short-term liquidity, evaluating how efficiently a company is paying creditors and short-term debts.
It can be used in any financial statement analysis and shows a company's ability to pay its suppliers.
Accounts Payable Turnover Ratio Formula
The accounts payable turnover ratio formula is calculated by net credit purchases by average trade payables.
Accounts Payable Turnover Ratio = (Net credit purchases / Average Trade Payables)
In Some cases, net purchases are used in the numerator instead of net credit purchases.
Average trade payables = (Creditors at the beginning of the year + Creditors at the end of the year) / 2, if the opening balance is not given, the closing balance can be used.
How do calculate Accounts Payable Turnover Ratio?
To calculate the accounts payable turnover ratio, you need to first calculate the average trade payables for the financial year.
It is an ABC company. Here is some information about the ABC company.
| Particular | Amount(₹) |
| Net credit purchases | 10,00,000 |
| Opening creditors | 2,00,000 |
| Opening creditors | 2,00,000 |
| Closing creditors | 2,50,000 |
Average Trade Payables = (₹2,00,000 + ₹2,50,000) / 2
Average Trade Payables = ₹2,25,000
Creditor Turnover Ratio = ₹10,00,000 / ₹2,25,000 = 4.44 times
It means ABC company has paid off its creditors around 4.44 times.
What are Accounts Payable/Creditors Days?
It tells us the number of days the company repays its creditors.
Creditors Days Formula & Example
It is calculated the following way,
Creditors Days = (365 / Creditors Turnover Ratio)
Creditors Days = (365 / 4.44) = 82.20 days
It means ABC company takes around 82.20 days to pay off its creditors.
As a rule of thumb, the higher the number of days taken for the company to pay off creditors, the better it is for the company.
Accounts Payable Turnover Ratio Interpretation
The accounts payable turnover ratio measures the company's efficiency regarding timely payment to suppliers & short-term debt obligations. A higher ratio is better than a lower ratio. It is good for the company if creditors allow them a long credit period. It is also advantageous for the company if it pays before time to take advantage of early payment discounts.
A higher payable ratio (the company is paying up creditors faster than the industry average) relative to the industry reflects that the company is not utilizing the credit facilities properly and management is not able to negotiate well with suppliers, for a reasonable credit period.
A lower accounts payable ratio reflects that company is not able to pay its creditors on time or company is requiring a higher number of days to pay back its creditors than the industry average (assuming that the company has a lot of debt obligations).
As a rule of thumb, the lower the creditor turnover ratio, the better it is for the company. This ratio depends on industry standards. This ratio is used to compare companies within the same sector.
What is a good Accounts Payable Turnover Ratio?
Accounts payable turnover depends on the average credit term days that you obtain from your suppliers and the payment procedures of your firm.
Policies must enable ongoing inventory shipments from suppliers, positive supplier credit histories, and vendor relationships. A good accounts payable turnover ratio in days depends on your business and benchmarking with your industry.
Limitations of Accounts Payable Turnover Ratio
Here are a few important limitations discussed below,
1. As with other financial ratios, it is important to compare a company's financial ratio to that of other businesses operating in the same sector. There may be a standard turnover ratio that is different to each industry.
2. When a company has a high turnover rate, which creditors and investors would consider a positive development, the ratio may be limited. if the ratio is noticeably higher than that of competing businesses in the same sector. It could be a warning that the business is not properly managing its capital or making investments in the future.
3. A high or low ratio, to put it another way, should not be taken at face value. Instead, it should compel investors to investigate the justification for the high or low ratio.
How to improve the Accounts Payable Turnover Ratio?
1. By paying bills considerably sooner, you can benefit from early payment reductions.
2. Increase sales revenue and sales turnover rate.
3. Increase account receivable collection to increase cash flow and speed up bill payments.
4. To fill funding gaps, use your business line of credit as needed.
Accounts Receivable Turnover and Accounts Payable Turnover
The accounts receivable turnover ratio is used to measure how efficiently a company collects its money owed by clients. It shows how well a company manages the credit lines it gives to the customers and how quickly collects its short-term debts.
The accounts payable turnover gauges at which rate a company pays its suppliers. Accounts payable turnover measures the number of times a company pays off its creditors in a year.
Accounts receivable turnover shows how fast a company received payments from its customers while accounts payable turnover shows how rapidly the company pays its suppliers.
Both ratios are calculated in a similar manner but it gives a different perspective on the financial activity of a company.
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