Managing your small business accounting processes is no easy feat. It is, however, a necessary part of ensuring your business is operating smoothly and is financially sound. It’s especially important to measure the liquidity of your business on a regular basis. Knowing your business is solvent—and taking steps to remedy things quickly if it isn’t—ensures your business will remain viable and healthy, even if the unexpected happens.
There are many measures of business liquidity. One that is often ignored is the accounts payable turnover ratio. This key performance indicator can quickly give you insight into the health of your relationships with your vendors, among other things.
Accounts payable turnover ratio is a measure of your business’s liquidity, or ability to pay its debts. The higher the accounts payable turnover ratio, the quicker your business pays its debts, but you’ll want to compare your accounts payable turnover ratio to that of other similar companies or to your company’s ratio for prior time periods to determine whether your ratio is good.
In this article, we’ll deconstruct the accounts payable turnover ratio, including how to calculate it and what it means for your business.
Accounts Payable Turnover Definition
Before we can understand how to calculate and use the accounts payable turnover ratio, we must first understand what the accounts payable turnover ratio is. In short, accounts payable (AP) represent the money you owe to vendors or suppliers. Accounts payable appears on your business’s balance sheet as a current liability.
When you purchase something from a vendor with the agreement to pay for the purchase later, you make an entry into your accounting system debiting an expense and crediting accounts payable.
The accounts payable turnover ratio measures only your accounts payable; other short-term debts—like credit card balances and short-term loans—are excluded from the calculation. The accounts payable turnover ratio can be calculated for any time period, though an annual or quarterly calculation is the most meaningful.
Accounts Payable Turnover Ratio Formula
The accounts payable turnover ratio formula isn’t complicated, but it does require some explanation. The formula is:
Total Purchases / ((Beginning Accounts Payable + Ending Accounts Payable) / 2) = Accounts Payable Turnover Ratio
- Total purchases are all the purchases on credit for the period under consideration. Remember, you only want to include purchases made and posted to accounts payable. You will exclude any purchases paid for with cash or by using a credit card. Some businesses exclude non-inventory purchases, but this is incorrect and can inflate your accounts payable turnover ratio.
- Beginning accounts payable is your accounts payable balance at the beginning of the period you are analyzing.
- Ending accounts payable is your accounts payable balance at the end of the same period. You can get these amounts from your balance sheet as of the beginning of the period and the end of the period, or you can use your accounts payable aging report from your accounting software.
Beginning Accounts Payable and Ending Accounts Payable are added together, and then the sum is divided by two in order to arrive at the denominator for the accounts payable turnover ratio.
Accounts Payable Turnover Ratio Example
Let’s clarify the accounts payable turnover ratio with an example. Say you made the following purchases over the course of the past year:
- Inventory on credit with your vendors: $135,000
- Inventory paid for with a check at the time of purchase: $25,000
- Office supplies on credit with the supplier: $12,000
- Meals on the company credit card: $600
- Window cleaning paid with cash: $120
Your accounts payable balance at the beginning of the year was $127,000, and at the end of the year, it was $74,000.
Let’s take your accounts payable turnover ratio calculation step by step:
For the purposes of the accounts payable turnover ratio calculation, your Total Purchases for the year were:
- Inventory: $135,000
- Office Supplies: $12,000
Meals and window cleaning were not credit purchases posted to accounts payable, and so they are excluded from the Total Purchases calculation. The inventory paid for at the time of purchase is also excluded, because it was never booked to accounts payable.
Your Total Purchases, then, were $147,000.
Beginning and Ending Accounts Payable
The accounts payable total on your balance sheet as of January 1 of the past year was $127,000. On the balance sheet dated December 31, it was $74,000. We calculate the denominator for the accounts payable turnover ratio as follows:
($127,000 + $74,000) / 2
$201,000 / 2
Completing the Accounts Payable Turnover Ratio Formula
Now the calculation becomes simple:
$147,000 / $100,500 = Accounts Payable Turnover Ratio
1.46 = Accounts Payable Turnover Ratio
In other words, your business pays its accounts payable at a rate of 1.46 times per year.
What Your Accounts Payable Turnover Ratio Means
So, is an accounts payable turnover ratio of 1.46 good or bad?
In and of itself, knowing your accounts payable turnover ratio for the past year was 1.46 doesn’t tell you a whole lot. You would need to compare your turnover ratio to other companies similar to yours, or you would need to compare this year’s turnover ratio to prior years’ ratios, to gauge whether your accounts payable turnover ratio is improving or declining.
There is another calculation that can give you more clarity, though. This calculation is Accounts Payable Turnover in Days:
Accounts Payable Turnover in Days = 365 / Accounts Payable Turnover Ratio
Using our example from above:
Accounts Payable Turnover in Days = 365 / 1.46
Accounts Payable Turnover in Days = 250
In short, in the past year, it took your company an average of 250 days to pay its suppliers.
In most industries, taking 250 days to pay would be considered slow payment. Your vendors might not be willing to continue to extend credit unless you raise your accounts payable turnover ratio and decrease your average days to pay.
A bigger concern, though, would be if your accounts payable turnover ratio continued to decrease with time. This could indicate your business’s financial health is deteriorating.
In the case of our example, you would want to take steps to improve your accounts payable turnover ratio, either by paying your suppliers faster or by purchasing less on credit. But there is such a thing as having an accounts payable turnover ratio that is too high. If your business’s accounts payable turnover ratio is high and continues to increase with time, it could be an indication you are missing out on opportunities to reinvest in your business.
The Importance of Your Accounts Payable Turnover Ratio
Your accounts payable turnover ratio tells you—and your vendors—how healthy your business is. Comparing this ratio year over year—or comparing a fiscal quarter to the same quarter of the previous year—can tell you whether your business’s financial health is improving or heading for trouble. Even if your business is otherwise healthy, having a low or decreasing accounts payable turnover ratio could spell trouble for your relationship with your vendors.
Like all key performance indicators, you must ensure you are comparing apples to apples before deciding whether your accounts payable turnover ratio is good or indicates trouble. If you decide to compare your accounts payable turnover ratio to that of other businesses, make sure those businesses are in your industry and are using the same standards of calculation you are.
Some companies will only include the purchases that impact cost of goods sold (COGS) in their Total Purchases calculation, while others will include cash and credit card purchases. Both scenarios will skew the accounts payable turnover ratio calculation, making it appear the company’s ratio is higher than it actually is.
For example, let’s say you chose to only include your inventory purchases in your accounts payable turnover ratio calculation, but you also included the inventory paid for at the time of purchase. Your accounts payable ratio, then, would be:
$160,000 / $100,500 = 1.59
The Final Word
Your accounts payable turnover ratio, not to be confused with accounts receivable turnover ratio, is an easy-to-calculate measure of your business’s liquidity. In order for it to be meaningful, you must compare your accounts payable turnover ratio for different time periods. If you choose to compare your accounts payable turnover ratio to other businesses, make sure you are looking at businesses like yours which are using the same standards of calculation you are using.
If you don’t have data for multiple periods, you can use your accounts payable turnover ratio to determine your accounts payable turnover in days. Comparing this number to your vendors’ payment terms will give you an idea of how solvent your business is.
Although your accounts payable turnover ratio is an important metric, don’t put too much weight on it. Consult with your accountant or bookkeeper to determine how your accounts payable turnover ratio works with other KPIs in your business to form an overall picture of your business’s health.
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