Businesses most times need to purchase materials from suppliers. To determine the rate at which these businesses make payments to their suppliers, you need to understand how to calculate and improve the accounts payable turnover ratio.
Accounts payable turnover ratio is one important accounting information every business should keep. With a knowledge of the turnover ratio, businesses will be able to make better financial decisions.
The turnover ratio enables creditors to make decisions as to the creditworthiness of the business. With the data obtained from the account payable ratio, interested persons can have information on the payment history of the business. To calculate the accounts payable turnover ratio, all you need to do is to divide the total of all purchases made within that period by the average balance.
A glance at the accounts payable turnover ratio will show you how many times a particular business has been able to offset its financial obligations to suppliers. The account payable records can be calculated annually, quarterly, or even monthly. At this point, you may be wondering how you can calculate the account payable turnover ratio.
The formula for the account payable turnover ratio is as follows:
TSP = total supplier purchases,
AP1 = Accounts Payable balance at the start of the period
AP2 = Accounts Payable balance at the end of the period.
To be able to improve the accounts payable turnover ratio, you will first need to understand how to calculate it. Calculating the turnover ratio is quite straightforward. All you need to do is to get the total purchases made from suppliers within the period in view. Divide the value of the total purchases by the average account payable balance.
The common question that will easily come to mind at this point is how to get the average account payable value. You can get this information by preparing a balance sheet report to capture the different supplier purchases made within the period in view. With the aid of accounting software, this data could be easily generated. However, you can calculate the value of the average accounts payable.
The steps you need to take in calculating the account payable turnover ratio are outlined as follows:
When you come across average accounts payable ratio, it refers to the sum of all unpaid balances for supplier purchases within a defined period. To get the average of these balances, sum up the values of the accounts payable ratio of the beginning and end of the period in view. Divide the total by two to arrive at the average balance.
Mathematically, the formula is expressed below:
Beginning accounts payable turnover + ending accounts payable turnover/2 = average accounts payable turnover ratio.
Company EFG, has its accounts payable balances as follows:
Accounts Payable balance April 1, 2020: $20,000
Accounts Payable balance July 31, 2020: $25,000.
Calculating the average account payable balance using the values above, you will have:
$20,000 + $25,000 = $45,000/2 = $22,500
The next step is, to sum up, all the purchases that were made on credit within the specified period. These purchases include due rents and utilities, products collected on credit for resale, credit purchases of production materials, and so on.
#3. Divide the total supplier purchases for the period by the value of the average accounts payable.
Calculating the accounts payable turnover ratio becomes very easy at this point. Once you have the total purchases from suppliers, divide it by the average payable ratio. Whatever value you get is the accounts payable turnover ratio.
Your account payable turnover ratio shows how fast you pay your creditors. This ratio can therefore impact the level of credit you get in the future. For better management of business cash flow and general financial health of businesses, a good account payable turnover ratio is vital.
If your account payable turnover ratio is not so great, there are ways you can improve it. Some of the things you can do to improve your account payable turnover ratio are as follows:
- Pay your suppliers on the due date: Since account, payable turnover ratio measures the rate at which businesses pay suppliers, making payments early will help to improve the turnover ratio. If you pay your bills within the agreed time, it will positively impact the turnover ratio. Making a payment on time does not necessarily mean you should pay before the time. Ordinarily, early payment is encouraged if there is a discount to be gotten from such early payment. Otherwise, just ensure you make payment on the agreed date and not after.
- Pay before the due date: Some vendors give some measure of discounts when you make payment on time. These discounts can be between 1-3% of the purchase. You can take advantage of such discounts by paying up within 10 days from the date the invoice was issued. Early parent strategy for turnover improvement is very essential. It not only helps you to increase your accounts payable turnover ratio but also ensures you save money along the line.
- Purchase of AP automation solutions: these are software that automates account payable processes. Through this software, purchase orders can be generated electronically. The automation process helps to ensure quicker invoicing, and fewer disputes. When a business invests in automation solutions, the business pays to enjoy a more cordial relationship with suppliers free from all manner of disputes. The use of automation solutions also ensures that businesses have enough data about payable and liabilities. This helps the finance department strategize on the best payment technique to adopt that will be best for the business.
It is not enough to know how to calculate e accounts payable turnover ratio. It is also vital to understand how to interpret it. Accounts payable turnover ratio shows how prompt businesses are in paying their vendors. If a business’s AP is high, it means that the business is paying off bills very fast. On the other hand, a low AP is an indication that the business delays in paying its suppliers.
So many other factors can affect the ratio of your account payable turnover. Without further investigation, you may not be able to determine the possible reasons why a business has a low AP. Different businesses have different AP levels.
An AP level that is considered ideal for the fashion industry may not be so great in the real estate industry. Therefore, before concluding that the AP of a business is either high or low, you may need to find out what is generally obtainable in the industry.
You may also have to keep an eye on the account payable turnover ratio during different business cycles. If you discover over time that the AP is usually high during certain periods of the year and low at other times, you may have to investigate further. On further investigations, you are likely to discover other factors that may be keeping the AP either high or low at these moments.
Account payable turnover ratio provides important data for businesses to make good decisions. Understanding the basics of account payable turnover and how it can be used to your advantage may be the bridge that will take your business from where you are to where you would want to be.