What are accounts payable?
Accounts payable (AP) is an accounting term that describes managing deferred payments or the total amount of short-term obligations owed to vendors, suppliers, and creditors for goods and services.
Since a company’s accounts payable balances must be paid in 12 months or less, they are categorized as a current liability in the financial statements like the balance sheet.
What are some accounts payable examples?
Standard charges that would fall under accounts payable and, as such, be listed on a vendor invoice include utilities, materials, payroll, insurance premiums, services (e.g., legal or marketing consultants), or rent.
Short-term debts, including a line of credit balance and long-term debt payments (principal and interest) due within a year, are also considered current liabilities.
Current assets are used to pay current liabilities. Current assets include cash and assets that can be converted to cash within 12 months.
For example, accounts receivable balances are converted into cash when customers pay invoices.
Did you know? Rho provides a fully automated AP process, including purchase orders, invoice processing, approvals, and payments.
What is the accounts payable turnover ratio?
The accounts payable (AP) turnover ratio measures how quickly a business pays its total supplier purchases.
The ratio measures how often a company pays its average accounts payable balance during an accounting period. The end of the period may be a month, quarter, or year.
Accounts payable turnover ratio formula
The accounts payable turnover ratio is (net credit purchases) / (average accounts payable).
Credit purchases are those not paid in cash, and net purchases exclude returned purchases.
How to calculate the accounts payable turnover ratio
To calculate the ratio, determine the total dollar amount of net credit purchases for the period. Note that purchases paid in cash are not part of the calculation.
Second, obtain the beginning and ending accounts payable balances for the period used for the calculation.
AP turnover ratio calculation example
Assume that Premier Construction has $2 million in net credit purchases during the third quarter of 2023, and the average accounts payable balance is $400,000. Premier’s AP turnover ratio is ($2 million / $400,000), or 5.
In the 4th quarter of 2023, assume that Premier’s net credit purchases total $3.5 million and that the average accounts payable balance is $500,000. Premier’s AP turnover ratio is ($3.5 million / $500,000), or 7.
To determine the correct KPI for your business, determine the industry average for the AP turnover ratio.
How to interpret the accounts payable turnover ratio
A high turnover ratio indicates a stronger financial condition than a low ratio. Generating a higher ratio improves both short-term liquidity and vendor relationships.
When a business can increase its AP turnover ratio, it indicates that it has more current assets available to pay suppliers faster.
A liquidity ratio measures the company’s ability to generate sufficient current assets to pay all current liabilities, and working capital is a metric to assess liquidity. Liquidity improves when managers collect cash quickly and carefully monitor cash outflows.
Working capital is calculated as (current assets less current liabilities), and management aims to maintain a positive working capital balance. In other words, businesses always want the current asset balance to be greater than the current liability total.
When Premier increases the AP turnover ratio from 5 to 7, note that purchases increased by $1.5 million, while payables increased by only $100,000.
Premier used far more cash (a current asset) to pay for purchases in the 4th quarter than in the 3rd quarter. The company has better liquidity and a higher working capital balance.
If the AP turnover ratio declines, it may indicate poor financial distress. The business needs more current assets to be converted into cash to pay accounts payable balances.
A decline in the AP turnover ratio may also be related to more favorable credit terms from suppliers. In some instances, a business can negotiate payment terms that allow the business to extend the period of time before invoices are paid.
However, a lower turnover ratio may indicate cash flow problems for most companies.
Stronger vendor relationships
As explained above, when the AP turnover ratio increases, it’s a signal that the business pays vendors faster.
This approach strengthens vendor relationships because vendors will view the business as a reliable customer who pays on time.
A company that generates sufficient cash inflows to pay vendors can also take advantage of early payment discounts. If, for example, a vendor offers a 1% discount for payments within ten days, the business can pay promptly and earn the discount.
Finding the proper balance
The best-managed companies find a balance between paying vendors quickly and maintaining a sufficient cash balance for business operations.
There’s an opportunity cost whenever a vendor is paid. When cash is used to pay an invoice, that cash cannot be used for some other purpose.
Managers should forecast cash inflows and outflows, consider invoice due dates, and plan cash spending carefully.
How to improve your accounts payable turnover ratio
To improve the AP turnover ratio, consider working capital, supplier discounts, and cash flow forecasting.
Step 1: Increase working capital
Increasing working capital provides more cash to pay vendors faster. Analyze both current assets and current liabilities, and create plans to increase the working capital balance.
Step 2: Take advantage of vendor discounts
Taking a vendor discount allows the business to reduce accounts payable using fewer dollars. Monitor all vendor discounts and take them if your available cash balance is sufficient.
Step 3: Forecast cash inflows and outflows
Effective cash management helps a company balance the goal of paying vendors quickly with the need to maintain a specific cash balance for operations. Maintain a cash forecast and update the forecast as more data is available.
Constant monitoring can help you avoid cash flow problems.
Wrap-Up: All about the AP turnover ratio
Monitoring the accounts payable turnover ratio can help you make informed decisions about cash flow management and vendor relationships.
Rho’s AP automation helps process payables in a single workflow — from invoice to payment — with integrated accounting.
- End-to-end functionality to manage AP and to forecast cash flows
- Ability to invest excess cash in government securities with next-day liquidity on U.S. Treasuries
- A scalable platform that grows as you grow
All wrapped up in unbeatable pricing and live customer support available 24H Mon-Fri, 10-7pm ET on weekends sounds nice to you,
Then, you should consider Rho. Schedule time with a Rho payments expert today!
Competitive data was collected as of January 10, 2024, and is subject to change or update.
FAQs: AP turnover ratio
Here are some frequently asked questions and answers about the AP turnover ratio.
What's the difference between the AP turnover ratio vs. the AR turnover ratio?
The AR turnover ratio measures how quickly cash is collected from customers. The AP turnover ratio, on the other hand, calculates how many times a company pays its average accounts payable balance in a period. One ratio focuses on receivables, and the other on payables.
The accounts receivable (AR) turnover ratio is (net credit sales) / (average accounts receivable).
Net credit sales represent sales not paid in cash and deduct customer returns from the sales total. Customer returns decrease both sales and profitability.
The receivable turnover ratio measures how often a business collects its accounts receivable balance during a specific period.
As stated above, the AP turnover ratio is (net credit purchases) / (average accounts payable). The AR turnover ratio measures how quickly receivables are collected, while AP turnover reports how quickly purchases are paid in cash.
Both benchmarks are important metrics for assessing a company’s financial health.
What's the difference between the AP turnover ratio and days payable outstanding?
Days payable outstanding (DPO) calculates the average number of days required to pay the entire accounts payable balance. The ratio is calculated as (average accounts payable) / (cost of goods sold). A lower ratio means that the cost of goods sold balance is paid in fewer days.
DPO differs from the AP turnover ratio in several ways:
- AP turnover ratio measures the number of times a company pays its average accounts payable balance, and DPO calculates the number of days required to pay the AP balance.
- The AP turnover ratio uses net credit purchases, while DPO uses the cost of goods sold (COGS). COGS includes purchases, labor costs and overhead required to create a product or deliver a service.
Managers may use these metrics on dashboards to perform financial analysis.
What's the difference between the AP turnover ratio vs. the creditors turnover ratio?
Accounts payable (AP) turnover ratio and creditors turnover ratio are essentially the same, albeit expressed differently. Both these ratios measure the speed with which a business pays off its suppliers.
Accounts payable (AP) turnover ratio
This ratio provides insights into the rate at which a company pays off its suppliers. Accounts payable are the amounts a company owes to its suppliers or vendors for goods or services received that have not yet been paid for.
The AP turnover ratio is calculated by dividing total purchases by the average accounts payable during a certain period.
Creditors turnover ratio
Creditors are also parties - typically suppliers - to whom the company owes money. Hence, the creditors turnover ratio also gives the speed at which a company pays off its creditors.
The calculation is essentially the same as the AP turnover ratio: total credit purchases divided by the average accounts payable.
In summary, both ratios measure a company's liquidity levels and efficiency in meeting its short-term obligations. They may be referred to differently depending on the region, industry, or even within different sectors of some companies, but they denominate the same financial metric.
Minor variances may arise due to slight differences in the components considered in the calculations, but in principle, the AP and Creditors turnover ratios serve the same purpose.
How is the trade payables turnover ratio related to the accounts payable turnover ratio?
The trade payables and accounts payable turnover ratios are basically the same concept referred to using different terminologies. Both metrics assess how quickly a business settles its obligations to its suppliers.
Trade payables turnover ratio
Trade payables are the amounts a company owes to its suppliers from whom it has purchased goods or services on credit.
The trade payables turnover ratio measures the speed at which a business pays these suppliers and is calculated by dividing total credit purchases by average trade payables during a certain period.
Accounts payable turnover ratio
As mentioned before, accounts payable are amounts a company owes for goods or services that it has received but has not yet paid for.
The accounts payable turnover ratio measures the rate at which a company pays off these obligations, calculated by dividing total purchases by average accounts payable.
In essence, both ratios are measures of a company's liquidity and the efficiency with which it meets its short-term obligations.
Whether the term "trade payables" or "accounts payable" is used can depend on regional or industry practices or may reflect slight differences in what is included in the accounts. However, fundamentally, both ratios serve the same purpose in financial analysis.
What does the accounts payable turnover ratio measure?
The ratio measures how many times a company pays its average accounts payable balance during a specific timeframe. The ratio compares purchases on credit to the accounts payable, and the AP turnover ratio also measures how much cash is used to pay for purchases during a given period.
Is a high AP turnover ratio good?
A high accounts payable turnover ratio indicates better financial performance than a low ratio. A higher ratio is a strong signal of a company’s positive creditworthiness, as seen by prospective vendors.
A business that generates more cash inflows can pay for credit purchases faster, leading to a higher AP turnover ratio. Faster payments also improve vendor relationships.
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