Accounts payable turnover ratio measures how many times in the period entity has paid all of its credit suppliers. In other words this ratio theoretically tells payoff frequency. Higher the frequency lesser the number of days taken by the entity to make payments to trade creditors.
Payables Turnover Ratio is measured using the formula given below:
Accounts payable turnover ratio = Purchases / Average payables
For measurement of this ratio by purchases we mean credit purchases only and the same should be used if information is available. If not, then we have no choice but to assume that all purchases were credit based. If purchases figure is not given then one can deduce it using cost of goods sold formula:
Purchases = Cost of goods sold + Closing Stock – Opening stock
Again if the opening and period ending inventory information is not available then cost of goods sold figure may be used as approximate figure of purchases. But it is hardly the case these days as most of the entities now a days use perpetual inventory system and therefore have inventory information on run-time basis.
Example
PakAccountants Inc. has just published year ended financial statements with following figures:
Cost of goods sold: 1,840,000
Opening inventory: 55,000
Closing inventory: 165,000
Entity makes all purchases on credit basis. Trade payables at the end of the year are 350,000. Comparative information shows that payables last year were 250,000.
Calculate accounts payable turnover ratio
Solution
Before calculating payables turnover ratio we need to determine few things like purchases and average payables.
Purchases = Cost of goods sold + Closing inventory – Opening inventory
= 1,840,000 + 165,000 – 55,000
= 1,950,000
Average payables = (opening payables + closing payables) / 2
= (250,000 + 350,000) / 2
= 600,000 / 2
= 300,000
Payables turnover ratio = Purchases / Average payables
= 1,950,000 / 300,000
= 6.5
Analysis and Interpretation
To better analyse PakAccountants payables activity we need comparative information and includes the following:
- Last year’s payable turnover ratio of PakAccountants
- Industry average payable turnover ratio
- Turnover ratio of competitors
Suppose industry average is 4 and PakAccountants last year ratio was 4.5. By comparing this year’s ratio with these two figures we can understand that PakAccountants has significantly improved on payment front and thus paying its creditors much quickly.
One of the reasons for early payment might be the cash discount available to the entity and thus entity is taking the benefits to save money. Another reason for such high turnover ratio can be that entity is making purchases in large volumes to get bulk order discounts.
Though high payable turnover ratio is usually considered good but it might also indicate that entity is not using credit facility and thus missing out on interest free capital available to it. To confirm that we need to look at other ratios and information especially interest cost and liquidity. If entity is paying much faster than industry’s normal payment cycle then entity can slow down a little and use the same cash to conduct its operations for which entity might be relying on short term loans and overdraft facilities and incurring interest cost.
On the other hand if payables turnover ratio is deteriorating or significantly low turnover ratio is probably indicating entity’s inability to make payments on time and thus deepening liquidity crises. However, to confirm this one has to look at liquidity ratios to corroborate the expectations raised by turnover ratio as low turnover ratio might be because new agreement between entity and its suppliers for longer credit term if supplier agrees on steady supply arrangements and entity agreeing to purchase solely from specific supplier.