In business, there are a lot of a financial transactions going on. You have to spend money to make money, and you have to make money to spend it. Account payable and accounts receivable are a company’s way of saying “this is the amount we owe” and “this is the amount we’re owed”, respectively. Working in the account receivable department can be exhausting, it’s akin to being a bill collector, hounding clients all day long to pay their bills or to remind them of upcoming due dates. (Working in the accounts payable department can be just as tedious but equally rewarding. Here’s what it takes to be part of the accounts payable team.) When you are the client on the other end of that phone your companies accounts payable turnover ratio is on the line. Find out more about finances and accounting for start-ups in a comprehensive online course.
What is an accounts payable turnover ratio?
A business that owes money to a client records their debt as an account payable. The account payable turnover ratio is a measurement on how fast you typically pay your accounts due and how many times the company pays these accounts during a specified time period. Even if you are a manager and not the business owner having knowledge on accounting can help you do your job more effectively. Learn essential accounting concepts in Accounting for Managers.
Having a high ratio is obviously a good thing, it means you are in good standing with your clients and that you have enough money to be in good standing with your clients. However, sometimes companies deliberately delay paying accounts due (otherwise known as extending the period of credit turnover) to gain more liquidity. Doing so results in a lower accounts payable turnover ratio.
How do I calculate this?
To calculate the accounts payable turnover you take the total amount of credit purchases made and divide it by the average accounts payable balance for a period of time. So it looks like:
Accounts payable turnover ratio = total credit purchases / average accounts payable balance
Since there is no line item that tells you the total amount your company purchased for a period (usually a year) you have to have another formula to calculate this number. You might assume that you can use the cost of sales on your income statement but this would be an incorrect total of purchases because you may have purchased 900 items for sale but only sold 700. This creates a discrepancy between what the expected cost of sales was and what it actually was. So, to remedy this discrepancy use this formula:
Total Purchases = Cost of sale + ending inventory – starting inventory
To figure out what you total purchasing cost was by day, week or month divide the answer by either 365, 52 or 12 accordingly.
How do I use the ratio?
When you figure out the accounts payable turnover ratio for your business it helps you (or you’re accounting department) assess your overall money situation. A high ratio indicates you are on top of your game paying your debts off in a timely manner. A lower ratio means things are moving a little slower. If you have a lot of outstanding debts it can substantially affect the overall health of your business. Unless, of course, you have accounted for all of this and have a serious stash of money just waiting to be paid out. Calculating this turnover ratio can indicate how your company is operating. By watching the accounts payable turnover ratio trends you can discover patterns in your business spending habits. An increase in this ratio can be an indication that your business is financially sound with no sight of declination. However, if this ratio is on a downward spiral it could be a warning sign that you either need a new accounts payable department or your financial condition is worsening. Understanding accounting fundamentals is going to help you understand business. Teach yourself accounting through a business perspective.
As for standard account payable time limits – there really aren’t any. As with anything, the payment requirements will vary from client to client. Some won’t require payment for a long time because they are capable of having a large accounts receivable balance. Contrarily, smaller business can’t afford to have outstanding debts so they may require quicker and/or more frequent payments. Learn more about finance management in this Accounting in 60 Minutes course.