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Accounts payable turnover is an integral financial ratio used to reflect a company’s ability to pay its suppliers and meet short-term financial obligations. Accounts payable turnover helps businesses analyze payment patterns and working capital management, and it can be compared to similar businesses or industry standards. In this blog post, we will explain how to calculate the accounts payable turnover formula, what is a good turnover ratio and how to use turnover rates to increase efficiency for your business.
The Accounts Payable Turnover is the number of times that a business can pay its accounts payable within a certain period out of its operating cash flow.
Accounts payable turnover indicates the number of times that a firm can repay the average accounts payable amount to the suppliers during a given period. It shows the rate at which a firm can repay the amount borrowed in the short run. Hence, higher accounts payable turnover signifies prompt repayment to vendors and good working capital management.
Accounts payable turnover formula
The formula for accounts payable turnover is:
Accounts Payable Turnover = Total Purchases / Average Accounts Payable
Where:
- Total Purchases: The aggregate sum of what a firm bought from suppliers on an accrual basis within a given period. This was usually worked out as the total Manufacturing Cost + the rise in Work-in-Progress.
- Average Accounts Payable: The average of the outstanding supplier invoices that the company had not paid during the specified period. Determine an average of the accounts payable balances at the start and end of that period.
For example, if a company made $3.5 million in total purchases last year and had an average unpaid supplier balance of $700,000 throughout the year, its accounts payable turnover rate would be:
To determine percentage of sales: $3,500,000 / $700,000 = 5
So, an accounts payable turnover ratio of 5 implies that the company made 5 times the average payables balance during 12 months.
What does a Good Accounts Payable Turnover Ratio look like?
A higher accounts payable turnover ratio is preferred, which means a company is effectively paying back to the vendors and managing the short-term liabilities. Low accounts payable turnover may indicate that there is poor management of cash, or that it is hard to pay its suppliers on time.
As a guideline for accounts payable turnover rates by industry:
- Retail companies: Approximately 12 times
- Manufacturers: 5 to 8 times turnover
- IT firms – approximately 6 times
Management should compare its AP turnover ratio to its counterparts in the industry and analyze figures over time to understand cash flow performance. Any significant increase or decrease in the scores requires further examination of what is causing this change.
Strategies to enhance the accounts payable turnover
If a company wants to reach optimal accounts payable turnover benchmarks for their sector, here are some tips:
- If financially feasible, accept discounts for timely payments
- Implement e-invoicing and render the approval process more efficient
- Assess supplier terms and extend time horizons where it is feasible
- Supply Chain financing or loans should be employed to optimize credit for extended payback periods.
- Analyse the reasons for a delay, for example, poor cash flow or inefficiencies in the payment system
All in all, it is useful to track accounts payable turnover regularly to understand how a business is dealing with vendor payments and short-term liabilities. This is because although higher turnover is usually desirable, the turnover rates vary by sector. By employing AP turnover metrics, businesses can identify the issues and adapt the management of cash flows to achieve the desired levels accordingly.