What is the Accounts Payable Turnover Ratio?
The accounts payable turnover ratio is a company's purchases made on credit as a percentage of average accounts payable. The formula for accounts payable turnover ratio is:
Accounts Payable Turnover = Net Credit Purchases/Average Accounts Payable
How Does the Accounts Payable Turnover Ratio Work?
Let's assume Company XYZ buys $10 million of widget parts this year. Of those purchases, $8 million was on credit, meaning that it did not pay immediately for the widgets it bought. Company XYZ usually carries an average of $400,000 in accounts payable on its balance sheet. Payables are liabilities, and as such, they appear on the balance sheet. In particular, accounts payable are current liabilities, meaning the amount owed is expected to be paid within the next 12 months.
Using this information and the formula above, we can calculate that Company XYZ's accounts payable turnover ratio is:
Payables Turnover Ratio = $8,000,000/$400,000 = 20
By dividing 365 days by the ratio, we find that Company XYZ takes about 18 days to turn over its accounts payable.
Why Does the Accounts Payable Turnover Ratio Matter?
Payables turnover is a measure of how well a company pays its bills. If it's too low, the company may be lax in paying what it owes and may soon be struggling to find the cash to pay the bills; if too high, the company may be unwisely paying too quickly and burning through cash. In general, payables levels correspond to changes in sales levels.
It is important to note that different industries have different norms and standards regarding payables turnover, and so determining whether a turnover ratio is high or low should be made within this context. It is also important to note that because the formula uses an average, it is possible that one or two purchases could artificially drive the numbers up or down.
