To find out how efficient the company is at paying to its creditors, suppliers or short term obligations, accounts payable turnover ratio is calculated.
Accounts payable is a short term liability shown in the current liability section on the balance sheet. It shows how much a company owes to its suppliers and creditors as at the balance sheet date. It’s also known as average payment period (APP).
Average payment period (APP) tells you how quickly the company is paying its bills. It measures the short term liquidity position of the company.
Accounts payable turnover ratio can be calculated by using following steps:
- Calculate net credit purchases.
- Add beginning and closing balance of accounts payable.
- Find average accounts payable by dividing step 2 by 2.
- Now divide step 1 with step 3 to get accounts payable turnover of the company.
You can use following formula to calculate net credit purchase:
Net credit purchases = cost of goods sold + ending inventory – starting inventory
You can subtract cash purchases from above calculation. However, in companies up-front cash payments to suppliers is normally very small that you can ignore it. However, based on the type of business, if you have higher cash purchases then it need to be adjusted while arriving at total net credit purchases.
Why to calculate accounts payable turnover ratio
Financial analyst are interested to measure the liquidity and operational efficiency of the company. To measure it, they base their decision on number of parameters. Accounts payable turnover ratio is one of those parameters.
Creditors are also interested to know how soon the company is making payments for the supplies or goods that the company takes on credit. If the accounts payable turnover ratio is high then it’s a good sign for the creditors as it indicates speedy payment for their dues.
To get more clarity on the short term liquidity position of the company, it’s always advised to compare with previous year figures. If by comparing, you find the accounts payable turnover ratio decreasing over the years, then it indicates that the company is taking longer time to pay its bills. It might me due to the financial stress of the company. A decreasing ratio is always not a bad thing, you need to get deeper into the financial statements and management commentaries on this. A decrease in such ratio can takes place when company has negotiated better payment terms with the suppliers.
Similarly, an increase in the ratio in comparison to previous years indicate that the company is paying off at a faster rate to its suppliers than the earlier periods. It also means that company has enough cash to take care of its business.
Example to calculate APT ratio
Company XYZ has following financial details for the current year:
- Total credit purchases for the year is Rs. 1,00,000
- Opening and closing balance of accounts payable is Rs. 30,000 and Rs. 40,000 respectively. You can get these figures from company’s balance sheet. Last year closing balance can be taken as this year’s opening balance.
From the above financial data, average accounts payable for the entire year is Rs. 35,000 [(30000+40000)/2]
Accounts payable turnover ratio equals to 2.86 for the year (Rs. 1,00,000/Rs.35,000). It means company XYZ paid off their suppliers/vendors 2.86 times during the year.
Similarly to know how good the company is in collecting cash from customers, financial analyst calculates account receivable turnover ratio.