An accounts payable turnover ratio typically measures the number of times a company pays its suppliers during a specific accounting period. It usually determines the ability of a company to manage and pay its liabilities to suppliers. Typically, the ratio provides investors an idea of how swiftly the company can settle its accounts.
The accounts payable turnover ratio can determine the short-term liquidity of a business. This aids investors in understanding liquidity since suppliers often require payment within 30-90 days. Payment requirements usually will vary from supplier to supplier, depending on its size and financial capabilities. A lower ratio usually signifies that a company is slow in paying its suppliers; conversely, a higher ratio means quicker settlement of the supplier debts.
To calculate the ratio, the total amount of purchases made from suppliers on credit is divided by the average accounts payable amount within the same time frame. Since it can be difficult to determine the real amount of purchases made on credit, it typically then is assumed that all purchases are made on credit. This is in conformity with the principle of Conservatism in Accounting, in which one anticipates losses and only recognizes a gain once it materializes.
Next, if the average accounts payable is not given, then it will need to be calculated. This is accomplished by adding the accounts payable beginning and accounts payable ending, and then the sum divided by two. Finally, the credit purchases should be divided by the average accounts payable to get the accounts payable turnover ratio.
For example, if annual purchases are $200,000 US Dollars (USD), the accounts payable beginning is $30,000 USD, and the accounts payable ending balance is $20,000 USD, it would be computed thus: 200,000 / ([30,000 + 20,000]/2). The accounts payable turnover ratio would be eight. This is the number that investors would want to view.
There generally are two reasons for a slower or falling accounts payable turnover ratio: either the business has a shortage of cash, or there could be disputes on the invoices forwarded by the suppliers resulting in slower payments. If a company does not pay its liabilities immediately, then it could mean it cannot pay its creditors. Also, this could mean that the company wants to extend the payment of payables for as long as it can.
The second implication of a low accounts payable turnover ratio means the company is successful and has good credit policy from its suppliers. This good credit policy typically allows the company to have favorable credit terms which enables it to use or invest cash in other undertakings. For instance, if the suppliers require payment every six months, then the company can invest its earnings for the six months prior to making a payment.