Accounts Payables are short-term liabilities that a business owes to its creditors including suppliers and vendors. They are a part of the current liabilities section under Liabilities in the balance sheet. The accounts payable turnover formula is in fact a measure of the short-term liquidity of a company. It measures the ability of the company to pay off its debts by quantifying the rate at which the business pays off its creditors or suppliers, over a given period.
This is done by comparing the total credit purchases of the company over an accounting period to the average Accounts Payable during that time. This ratio helps in determining the ability of the company to pay off its debts and is often used by creditors to analyze the liquidity of the company so that they can decide whether to extend credit to this company or not.
The Accounts Payable Turnover Ratio Formula
The Accounts Payable Turnover Ratio Formula is calculated by dividing the total purchase by the average Accounts Payable for that period. To calculate that, the company needs to obtain a total of its credit purchases for a year divided by the average Accounts Payable for the year.
The total credit purchases for the year can be calculated using the figures from the income statement by using the following formula which requires adding Closing inventory to total Credit Purchases and then deducting Opening Inventory from this total. Any purchase returns must be subtracted from this figure. The Average Accounts Payable will then be calculated by adding opening Accounts Payables to Closing Accounts Payables and then dividing them by two to arrive at the average. These have been further shown below:
Average Accounts Payables = (Total Credit Purchases for the Year/ Average Accounts Payables)
Total Credit Purchases for the Year = Closing Inventory + Credit Purchases – Opening Inventory
Average Accounts Payable = (Opening Accounts Payable+ Closing Accounts Payable) / 2
Accounts Payable Turnover in Days
To calculate the Accounts Payable Turnover Ratio in a number of days instead of the ratio form, the ratio itself can be divided by 365. This will give the total ratio in the number of days.
Accounts Payable Turnover in Days = 365 / Accounts Payable Turnover Ratio
Company A reports total credit purchases of $120,000 before purchase return of $10,000 for the year ended June 30, 2021. The Accounts Payable balance at the beginning of the year was $12,000 and the balance at the closing of the year was $25,000. To calculate the Accounts Payable Turnover ratio for the year, the company will use the following formula:
Accounts Payable Turnover Ratio= 5.95
This can be interpreted as that during the year, the company paid off its vendors 5.95 times.
Accounts Payable Turnover in Days= 365/5.95 = 61.34 Days
This can be interpreted as that during the year, the company took 61.34 days to pay off its suppliers and vendors.
The ratio is interpreted as the ability of the company to pay off its short-term debts and creditors and therefore, the ability of the company to fulfill short-term obligations. It is generally considered best for this ratio to be higher to be most favorable for the business. The higher the ratio, the greater the ability of the company to meet its short-term obligations more quickly.
The lower the ratio, the longer the company will take to fulfill its obligations to pay off its suppliers and creditors. This is again useful for new creditors or suppliers when they are considering extending a credit line to the company and will therefore decide based on the company’s ability to meet this requirement of being able to pay on time and regularly throughout the year.
As the Accounts Payable Turnover ratio tells how quickly the company pays off its vendors and suppliers, it is usually used by its creditors, vendors, and suppliers to gauge the liquidity of the company. Suppliers can use it to find out the most likely time the company will take to pay them. Creditors often use this ratio to find out whether it’s feasible to extend a line of credit to this particular customer or not while taking into account other factors as well.
This is because this ratio is essentially a measure of a company’s liquidity. When the ratio for a company is higher, it is generally believed that the company will be able to pay off its vendors quickly and efficiently and therefore, can also be useful in getting better credit terms from the vendors in the future as this ratio supports the company’s credit history.
When a company maintains a good Accounts Payable Turnover Ratio, it is able to quickly gain the trust of its creditors and vendors and is able to receive the required credit more easily as compared to companies with low Accounts Payable Turnover Ratio. This is because creditors believe that companies with a higher Accounts Payable Turnover Ratio pay off their suppliers and vendors more regularly and frequently and therefore, it is considered to be of less risk to extend credit to them.
In spite of the fact that companies with lower Accounts Payable Turnover Ratio are generally deemed to be riskier in terms of being extending credit lines and vendors might be reluctant to believe in their ability to pay back their short-term debts, it is important to note that the Accounts Payable Turnover Ratio has some limitations to it.
When creditors are considering the Accounts Payable Turnover Ratio for a company, it is important to compare the ratio of one company to other companies in the industry as well. It is quite possible that the industry-wide Accounts Payable Turnover Ratio might be low for a particular industry given the nature of its business.
A very high ratio could also be problematic. If a company’s Accounts Payable Turnover Ratio is much higher than that of other companies in the industry, this would mean that this company is perhaps not utilizing its cash properly and has too much cash accessible all year round. This can have other implications for the future of the company.
Therefore, a high or low Accounts Payable Turnover Ratio for any company should not be taken into account in isolation without a proper comparison with other companies in the industry.