Accounts Payable Turnover Ratio Definition
The amounts payable turnover ratio of a company is the rate at which a company pays the debts or owes its suppliers or vendors. This ratio is a short-term liquidity ratio that measures the number of times a company pays off its suppliers during a period of time. Accounts payable is the short-term debt a company owes is suppliers.
The ability of a company to pay off accounts payable and how efficient it is in paying is reflected in the accounts payable turnover ratio of the company.
How to Calculate the Accounts Payable Turnover Ratio
The accounts payable turnover ratio is a liquidity ratio that compares the net credit purchases by a company to the average accounts payable at a particular time. The Formula for calculating the accounts payable turnover ratio is;
Average Accounts Payable
There are two ways of calculating the average accounts payable of a company. First, you can deduct the accounts payable balance at the beginning of the period from the accounts payable balance at the end of the period to arrive at the average. Second, you can divide the total accounts payable for the beginning and end of the period by 2.
What Does the Accounts Payable Turnover Ratio Tell You?
The accounts payable turnover ratio of a company is an indicator of solvency or insolvency of a company relating to how quick a company pays off debt or owes its suppliers. Also, the number of times a company pays off its accounts payable is reflected in the turnover ratio.
Basically, the accounts payable turnover ratio of a company is an indicator of the amount of cash or revenue the company owns. It also measures the extent at which the company meets short-term debt obligations.
A Decreasing Accounts Payable Turnover Ratio
A company can either have a decreasing turnover ratio or an increasing turnover ratio. When a company takes longer time to pay off short-term debts, it will have a decreasing turnover ratio. A company that takes longer time before paying off clients of regarded weak financially, thereby not attractive to investors.
On the other hand, having a decreasing accounts payable turnover could mean that the company has negotiated with suppliers it owes.
An Increasing Accounts Payable Turnover Ratio
A company that has an increasing accounts payable turnover ratio pays off its debt at a faster speed when compared with previous periods. An increasing turnover ratio indicates a positive management of short-term debts and accounts payable by a company. It also indicates some level of financial strength in the company.
However, an increasing turnover ratio is not always a positive indication, it could be as a result of failure of the company to reinvest in the business. When a company is spending all its revenue to pay off debts without reinvesting into the business, it will have an increasing turnover ratio which is not healthy for the growth of the company.
Here are some important points to hold onto:
- An accounts payable turnover ratio is a liquidity ratio (short-term) that measures how well a business pays off its accounts payable during a period of time.
- The turnover ratio also indicates the number of times the company pays it debts in a given period.
- Having a decreasing turnover ratio does not necessary mean the company does not have the financial capacity to pay debts, rather, the company may be reinvesting in the business.
- An Increasing turnover ratio might not necessarily mean that the company is solvent, it could be that the company is not reinvesting in its business.
Example of the Accounts Payable Turnover Ratio
If Company A buys inventory from a vendor for the past year and the inventory worths $150 million after the accounts payable at the beginning of the year and at the end of the year is calculated. The turnover ratio for the company would be calculated using;
Average Accounts Payable
(average accounts payable is calculated by subtracting the payable balance at the beginning of the period from the accounts payable balance at the end of the period).
This formula can be used in calculating the turnover ratio for all available companies.
The Difference Between the Accounts Payable Turnover and Accounts Receivable Turnover Ratios
The accounts receivable turnover ratio is the opposite of accounts payable turnover ratio. It measures the rate at which a company collects the money owed by customers. It reflects the speed at which short-term debt is paid to a company by its customers. This reveal the effectiveness of the company in managing its credits.
Accounts payable turnover ratio deals with the rate at which a company pays off its accounts payable, money or owes suppliers or vendors). Both terms are two sides of a coin. While the former shows how quickly a company is paid by its customers, the later shows how fast a company pays off its debts.
Limitations of Using the Accounts Payable Turnover Ratio
There are certain limitations attributable to the use of accounts payable turnover ratio by companies. Usually, financial ratios are used in comparing companies in relation to their performance. In the case of accounts payable turnover ratio, it might be inaccurate to compare two companies that have high turnover ratios for example. One of the two companies might not be reinvesting into its business causing an increasing ratio while the other company may by reinvesting and at the same time paying off its debts fast. Now, comparing these two companies just because they have high turnover ratios is not a healthy comparison. Therefore, investigating why a company has either high or low turnover ratio is essential.
Reference for “Accounts Payable Turnover Ratio”
Academic research on “Accounts Payable Turnover Ratio”
Performance evaluation of Turkish cement firms with fuzzy analytic hierarchy process and TOPSIS methods, Ertuğrul, İ., & Karakaşoğlu, N. (2009). Performance evaluation of Turkish cement firms with fuzzy analytic hierarchy process and TOPSIS methods. Expert Systems with Applications, 36(1), 702-715. In today’s competitive environment evaluating firms’ performance properly, is an important issue not only for investors and creditors but also for the firms that are in the same sector. Determining the competitiveness of the firms and evaluating the financial performance of them is also crucial for the sector’s development. The aim of this study is developing a fuzzy model to evaluate the performance of the firms by using financial ratios and at the same time, taking subjective judgments of decision makers into consideration. Proposed approach is based on Fuzzy Analytic Hierarchy Process (FAHP) and TOPSIS (Technique for Order Preference by Similarity to Ideal Solution) methods. FAHP method is used in determining the weights of the criteria by decision makers and then rankings of the firms are determined by TOPSIS method. The proposed method is used for evaluating the performance of the fifteen Turkish cement firms in the Istanbul Stock Exchange by using their financial tables. Then the rankings of the firms are determined according to their results.
Impact of working capital management on profitability, Agha, H. (2014). Impact of working capital management on profitability. European Scientific Journal, ESJ, 10(1). The main purpose of this study is to empirically test the impact of working capital management on profitability .To investigate this relationship between these two, the author collected secondary data from Glaxo Smith Kline pharmaceutical company registered in Karachi stock exchange for the period of 1996-2011. For this purpose, in this study we use variable of return on assets ratio to measure the profitability of company and variables of account receivable turnover, creditors turnover, inventory turnover and current ratio as working capital management criteria. The results of the research show that there is a significant impact of the working capital management on profitability of company. Therefore, managers may enhance the profitability of their firms by minimizing the inventory turnover, account receivables ratio and by decreasing creditors turnover ratios but there is no significant effect of increasing or decreasing the current ratio on profitability. So, the results indicate that through proper working capital management the company can increase its profitability. This study will benefit the Pharmaceutical companies in the management of their working capital in such an efficient manner so that they can multiply their profitability.
Cash flows, ratio analysis and the WT Grant Company bankruptcy, Largay III, J. A., & Stickney, C. P. (1980). Cash flows, ratio analysis and the WT Grant Company bankruptcy. Financial Analysts Journal, 36(4), 51-54.
Accounting turnover ratios and cash conversion cycle, Ortín-Ángel, P., & Prior, D. (2004). Accounting turnover ratios and cash conversion cycle. Problems and Perspectives of Management, 1, 1-19. Financial statements, and especially accounting ratios, are usually used to evaluate actual managerial performance and predict the consequences of their decisions (firm value or financial distress). For a better understanding of the empirical results, and to improve the correct evaluation of managerial decisions, it is necessary to establish a link between accounting ratios and concrete managerial decisions. This paper analyses the relationship established between accounting turnover ratios and the period of time spent concluding and operational process. In order to achieve this purpose, not only a set of possible averages of real conversion periods are defined, but also the conditions that guarantee that accounting turnover ratios offer a good approach to them are established. In general, the conditions which enable to approach accounting turnover ratios on good terms are difficult to accept in firms operating in growing or declining markets, with seasonal demand or with long operating cycles. On the other hand, some possible alternatives which, without needing more information, can help to measure real conversion periods of time in a more accurate way are also proposed and illustrated.