The accounts payable turnover ratio is a liquidity ratio that indicates the ability a company has to repay its accounts payable. The repayment is done by comparing net credit purchases to the average accounts payable during a period. Basically, the accounts payable ratio shows how many times a firm can repay its average accounts payable balance over the year. Let’s take a closer look at the definition of this ratio, how you can utilize it, and the formula you need to calculate it.
Accounts Payable Turnover Ratio – Why is it Important?
With the accounts payable turnover ratio, creditors can analyze a firm’s liquidity by measuring how easy it can repay its present suppliers and vendors. When firms make payments throughout the year on supplies, it demonstrates to a creditor that they are able to make principal payments and regular interest. In addition, vendors use this ratio when they are considering establishing a new line of credit for a new customer. As an example, music stores and car dealerships usually pay for their inventory with floor plan financing from their vendors. In order to ensure that they’ll receive payment on time, vendors will analyze a firm’s payable turnover ratio.
Analyzing Accounts Payable Turnover Ratio
So, if the accounts payable turnover ratio shows the speed with which a firm repays its vendors, it is used by creditors and suppliers to help decide if they will grant credit to a firm. As with most liquidity ratios, a higher one is preferred over a lower one. If the ratio is higher, it shows suppliers and creditors that the firm is on time with bills. It also shows that new vendors will be repaid quickly. Moreover, if the turnover ratio is high, it can be used to negotiate favorable credit terms in the future. Just like with all ratios, this one is specific to certain industries. Each industry has its own standards. Therefore, this ratio is best used to compare similar companies in the same industry.
How is it Calculated?
If you want to calculate the accounts payable turnover ratio, you have to divide the total purchases by the average accounts payable for the year. The formula should go like this:
Usually, the total purchases number is not readily available on any general-purpose financial statement. That means they will have to be calculated. You can do so by adding the ending inventory to the cost of goods sold and subtracting the beginning inventory. Companies usually keep a record of supplier purchases, so you don’t have to also do this calculation. In order to find the average accounts payable, you have to add the beginning and ending accounts payable together and divide by two. Now that you made it to the end of the article, you are hopefully more familiar with this concept and what it includes. It may seem complicated at first, but you’ll be able to calculate it once you know how it’s done.