Accounts Payable Turnover Ratio: Formula, How to Calculate, and Improve It

Introduction

In the vast landscape of business operations, many factors contribute to a company’s success and financial health. While some aspects may take center stage, others quietly operate beneath the surface, yet have significant influence. One crucial aspect that quietly influences its financial health is accounts payable.

One important metric you should track to gauge the health of your accounts payable process is the accounts payable turnover ratio. In this guide, we’ll break down everything you need to know about the accounts payable turnover – from what it is to – how to calculate and improve it.

What is the Accounts Payable (AP) Turnover Ratio? 

The accounts payable turnover ratio is a financial metric that measures how efficiently a company pays back its suppliers. It provides important insights into the frequency or rate with which a company settles its accounts payable during a particular period, usually a year. 

Importance of Your Accounts Payable Turnover Ratio

The AP turnover ratio is a crucial indicator of a company’s financial health and operational efficiency. Here’s why it matters:

Cash Flow Management: A high AP turnover ratio indicates that a company is efficiently managing its cash flow by paying off its suppliers promptly. Conversely, a low ratio may suggest that the company is struggling to meet its payment obligations, which can lead to cash flow problems.

Supplier Relationships: Maintaining a healthy AP turnover ratio is essential for fostering positive relationships with suppliers. Timely payments can lead to better terms, discounts, and even preferential treatment from suppliers, ultimately benefiting the company’s bottom line.

Operational Efficiency: A high AP turnover ratio is often associated with streamlined processes and efficient operations. It reflects the company’s ability to manage its inventory effectively and negotiate favorable payment terms with suppliers.

Financial Analysis: Investors and creditors use the AP turnover ratio as part of their financial analysis to assess a company’s liquidity, financial stability, and payment practices. It provides valuable insights into the company’s ability to meet its short-term obligations.

How to Calculate AP Turnover?

Calculating the accounts payable turnover ratio is relatively straightforward. You just need two pieces of information: your total purchases and your average accounts payable. It is calculated by dividing the total purchases made on credit by the average accounts payable during that period.

Accounts Payable turnover formula

The formula for calculating Accounts Payable Turnover is:

In the above accounts payable turnover equation

• The total credit purchases refer to the total amount of purchases made on credit by the company. This includes goods or services acquired from suppliers or vendors with an agreement to pay at a later date.
• The average accounts payable is calculated by taking the sum of the beginning and ending accounts payable balances and dividing it by two. It represents the average amount of money owed to suppliers during the specified period.

AP turnover ratio calculation example

Let’s break down the steps with an example:

1. Total Purchases: Start by determining your total purchases for the period. This includes all purchases made on credit from suppliers and vendors. For example, let’s say your total purchases for the year were $500,000.
2. Average Accounts Payable: Next, calculate your average accounts payable. This is done by adding the accounts payable at the beginning and end of the period and dividing by two. For example, if your accounts payable at the beginning of the year were $50,000 and at the end of the year were $70,000:

Average Accounts Payable =($50,000+$70,000)/2 = $60,000

3. Now, plug these values into the accounts payable turnover equation :

   AP Turnover Ratio = $500,000/$60,000 ≈ 8.33

   So, in this example of account payable turnover equation, the ratio is approximately 8.33 times. This means that the company pays off its average accounts payable about 8.33 times during the year.

By calculating the AP turnover ratio regularly, you can gain insights into your payment management efficiency and make informed decisions to optimize your accounts payable process.

Account Payable Turnover Ratio Interpretation & Analysis

The AP turnover ratio provides valuable insights into a company’s payment management efficiency and financial health. It provides insights into liquidity, working capital management, and the company’s ability to meet its financial obligations. 

Here’s how to interpret and analyze this ratio:

• High AP turnover ratio

  A higher AP turnover ratio indicates that a company is paying off its suppliers quickly, fostering strong relationships. This suggests efficient payment management and strong cash flow, as the company is not allowing debts to linger. This can lead to improved working capital management and better utilization of available funds.

• Low AP turnover ratio

  Conversely, a lower ratio may indicate slower payment to suppliers, which can strain relationships and affect credit terms. A low ratio may indicate that the company is holding onto cash for too long, potentially missing out on discounts for early payment or facing penalties for late payment, which needs to be addressed. 

It’s essential to compare the AP turnover ratio with industry benchmarks or historical data to assess performance relative to peers or previous periods. A significantly higher or lower ratio than industry averages may warrant further investigation into the company’s payment practices, supply chain efficiency, or financial strategy.

How to Increase AP Turnover Ratio

Before delving into the strategies for increasing the accounts payable (AP) turnover ratio, let’s understand the reasons behind the need for such adjustments.

Why does a company need to increase its AP turnover ratio?

•  Improves cash flow: Increasing the AP turnover ratio helps improve cash flow by reducing the cash tied up in accounts payable. This can free up funds for other purposes, such as investment or debt repayment.
• Enhances relationships with suppliers: Paying suppliers promptly can foster good relationships and may lead to favorable terms, discounts, or preferential treatment in the future.
• Reduces interest expenses: By paying bills on time, companies can avoid late payment penalties or higher interest charges on outstanding balances.

Strategies to increase AP turnover Ratio

• Negotiate favorable terms: Seek discounts or early payment incentives from suppliers to encourage prompt payment.
• Streamline accounts payable processes: Implement efficient systems and procedures to expedite invoice processing and payment approval.
• Optimize cash flow management: Forecast cash flows accurately and plan payments accordingly to ensure timely settlements.
• Maintain good communication with suppliers: Proactively communicate with suppliers to address any payment issues promptly and maintain strong relationships.

How To Decrease AP Turnover Ratio 

While a high AP turnover ratio is generally considered beneficial, there are situations where decreasing the ratio can be advantageous. By intentionally slowing down the payment of accounts payable, businesses can achieve several benefits:

Why do Companies need to decrease their AP turnover ratio ?

1. Preserves cash reserves: In certain situations, companies may intentionally choose to delay payments to suppliers to preserve their cash reserves. This can be particularly relevant during periods of financial uncertainty or when there are more profitable short-term investment opportunities available.
2. Helps negotiate better terms: A lower AP turnover ratio can provide leverage during negotiations with suppliers. By extending payment terms, companies may be able to secure more favorable pricing or contractual terms.
3. Manages working capital: Lowering the AP turnover ratio can help manage working capital and align payment obligations with cash inflows more effectively.

Now, let’s explore some strategies to increase or decrease the AP turnover ratio:

Strategies to decrease AP turnover ratio:

• Negotiate extended payment terms: Engage in discussions with suppliers to negotiate longer payment periods to preserve cash flow.
• Prioritize payments strategically: Assess the financial impact and urgency of each payment to determine the optimal timing for settlement.
• Improve working capital management: Analyze inventory levels, accounts receivable, and cash flow patterns to align payment obligations with available cash better.
• Explore alternative financing options: Consider short-term financing solutions to bridge any temporary gaps in cash flow without impacting the AP turnover ratio significantly.

Remember, the decision to increase or decrease the AP turnover ratio should be based on the specific circumstances and financial goals of the company. It’s essential to strike a balance between maintaining good relationships with suppliers and managing cash flow effectively.

AP Turnover vs. AR Turnover Ratios 

Accounts Payable (AP) Turnover Ratio and Accounts Receivable (AR) Turnover Ratio are both important financial metrics used to assess different aspects of a company’s financial performance. 

Here’s a comparison between the two:

How to Track Accounts Payable Turnover 

To track accounts payable turnover, you can follow these steps:

• Determine the Reporting Period: Decide on the time frame for which you want to calculate the accounts payable turnover ratio. It could be monthly, quarterly, or annually, depending on your preference and the availability of data.
• Calculate Average Accounts Payable: Add the accounts payable balance at the beginning and end of the reporting period, and then divide it by 2 to get the average accounts payable.
• Average Accounts Payable = (Beginning Accounts Payable + Ending Accounts Payable) / 2
• Calculate Net Credit Purchases: Determine the total credit purchases made during the reporting period. Exclude cash purchases and any returns or allowances.
• Calculate Accounts Payable Turnover Ratio: Divide the Net Credit Purchases by the Average Accounts Payable to calculate the accounts payable turnover ratio.
• Interpret the Ratio: The resulting ratio indicates how many times, on average, you pay off your accounts payable during the reporting period. A higher turnover ratio implies more frequent payments and better accounts payable management.
• Compare with Industry Benchmarks: It can be helpful to compare your accounts payable turnover ratio with industry benchmarks to evaluate your performance and identify areas for improvement.
• Monitor Changes Over Time: Track the accounts payable turnover ratio over multiple reporting periods to monitor trends and identify any significant changes. This will provide insights into the effectiveness of your accounts payable management strategies.

How to Leverage Technology to Improve Your Accounts Payable Turnover Ratio?

In today’s digital era, leveraging technology can significantly enhance your accounts payable processes and positively impact your AP turnover ratio. By incorporating technologies like Highradius’ accounts payable automation software, you can streamline your operations and improve efficiency.

Here’s how: 

• Streamlined invoice processing

  Implement AI invoice data capture to reduce errors and speed up processing, leading to faster payment cycles and improved AP turnover.

• Enhanced validation and matching

  Use technology for automated validation against purchase orders and receipts, preventing errors, reducing discrepancies, and ensuring smoother processing.

• Exception handling efficiency

  Utilize advanced exception handling modules to swiftly identify and resolve exceptions, minimizing delays and improving overall AP turnover.

• Reporting and analytics

  Leverage technology for robust reporting and analytics to identify bottlenecks, optimize workflows, and make informed decisions to improve the AP turnover ratio.

• Improved operational KPIs

  Achieve high invoice capture rates, handle more exceptions per day, and ensure 100% visibility of accounts payable to improve operational efficiency and control.

• Delivering business outcomes

  Reduce processing costs, optimize cash outflow, and achieve desired DPO targets to enhance financial management and strengthen supplier relationships, ultimately improving the AP turnover ratio.

By leveraging technology solutions that automate and optimize your accounts payable processes, you can streamline operations, reduce processing time and costs, improve compliance, control fraud, and ultimately enhance your accounts payable turnover ratio.

Conclusion

In conclusion, mastering the Accounts Payable Turnover Ratio is not just about crunching numbers; it’s about gaining valuable insights into your company’s financial health and operational efficiency. 

Whether you aim to increase your turnover ratio to free up cash flow or negotiate extended payment terms to preserve capital, strategic management of accounts payable is key. With the right tools and strategies in place, you can elevate your company’s financial performance and pave the way for a brighter future. 

FAQs

1) What is the average payable turnover ratio?

A: The average payable turnover ratio can vary across industries and companies. It is important to benchmark against industry peers to determine what is considered average for a specific sector. Generally, higher turnover ratio (between 6 to 10) indicates more efficient management of accounts payable.

2) Is a high AP turnover ratio good?

A: Yes, a high accounts payable turnover ratio is generally considered favorable. It suggests a company’s ability to pay off its accounts payable quickly. It signifies robust cash flow management, where funds are readily available to honor obligations, fostering trust and reliability among suppliers. 

3) What is a good AP to AR ratio?

A: A good AP to AR (Accounts Payable to Accounts Receivable) ratio is typically greater than 1:1, suggesting effective cash flow management with AP more than AR. A ratio closer to 2:1 in favor of AR is considered healthy, while a ratio closer to 3:1 may suggest opportunities for business investment.

4) What is a good turnover ratio?

A: Every industry has its own benchmarks, when it comes to a good turnover ratio. But ideally in most industries, the turnover ratio between 6 and 10 is considered good. Ratios below 6 may indicate that the business is not generating sufficient revenue to meet its supplier obligations consistently.

5) What is the difference between the DPO and AP turnover ratio?

A: Days Payable Outstanding (DPO) measures the average number of days it takes a company to pay its AP. But AP turnover ratio measures how quickly a company pays off its accounts payable within a specific period. In short, DPO is about the timing of payments, while AP turnover ratio is about frequency.