How Accounts Payable Turnover Ratio Works

Accounts payable (AP) accounts for the amount of a company's short-term debt to suppliers incurred from purchasing goods or services in credit. On the balance sheet, accounts payable is under the current liabilities section since the debts are usually settled within 12 months.

The accounts payable turnover ratio can indicate whether a company can manage its short-term obligations well. A poor AP turnover ratio may suggest that a company is repeatedly unable to pay its debt in time during the period.

The formula to calculate the accounts payable turnover ratio is as follows:

AP Turnover Ratio = Total Credit Purchases / Average Accounts Payable

Where Average Accounts Payable = (Beginning Accounts Payable + Ending Accounts Payable) / 2

To find out AP turnover, first, we need to determine the average accounts payable. You can do this by adding the balance of accounts payable at the beginning of the period and accounts payable at the end of the period. Then, divide the result by 2 to get the average. Afterward, divide the total purchases from suppliers in credit during this period by the average accounts payable.

Analysts typically compare the value of AP turnover ratios from this period and the last period. Generally, a higher AP turnover ratio than before means that the company can settle its debts at a comfortable rate. On the contrary, a lower AP turnover ratio indicates that the company takes longer than average to pay off debts.

Example of Accounts Payable Turnover Ratio

For the year 2020, XYZ Company had purchased various supplies on credit from multiple vendors. In total, these supplies cost them around $1.5 million. Taking a look at the balance sheet of this year and last year can give us the information about the beginning and the ending accounts payable: $200,000 and $400,000 respectively. It's possible to calculate the AP turnover ratio using these data.

First, find the average accounts payable: ($200,000 + $400,000) / 2 = $300,000.

Then, get the value AP turnover ratio by dividing total credit purchases with the average accounts payable: $1,500,000 / $300,000 = 5.

Thus, we can determine that XYZ company has an AP turnover ratio of 5 in 2020.

Compare this year's result with the previous year's to get a picture of XYZ Company's financial condition. For instance, the company's AP turnover ratio for 2019 is 4.

In this case, the XYZ Company may have suffered from some financial difficulty in 2020. A decreasing ratio doesn't always reflect a negative situation, though a thorough investigation is necessary to determine the real cause.

Significance of Accounts Payable Turnover Ratio

The trend of AP turnover ratios of a company over the years can indicate a company's overall debt situation. Although, the ratio alone won't give a clear-cut answer. For example, a company may have a lower ratio not because it accumulates more debts but by rearranging different payment schedules with its suppliers. The opposite is also true.

Higher AP turnover indicates that a company is successful in paying off more debts. However, if the ratio is too high, that can also mean that the company's management fails to use the money to invest in capital. It's good that the company has less trouble managing debts, but the company could've used some of the money to improve the business instead and promote growth. The AP turnover ratio can't be the sole indicator, and further analysis is needed to conclude.

Comparing the AP turnover ratio of multiple companies is also a good idea. Keep in mind, however, that each industry has a different standard regarding debt. For instance, corporations that have a steady consumer base like utility companies generally have lower ratios. On the other hand, technology companies shouldn't rely too much on debt since their profitability are relatively more volatile, resulting in higher ratios.