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Why the Accounts Payable Turnover Ratio Matters for Your Business

Why the Accounts Payable Turnover Ratio Matters for Your Business
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Research suggests that a whopping 55% of new businesses close within 5 years of starting and only 33% are able to survive beyond 10 years or more. One of the top most reasons for businesses to fail is lack of capital and adequate funds or liquidity to run day-to-day business operations. Poor management and marketing are a close second.  

The ideal accounts payable turnover ratio (APT) is a financial metric that measures how efficiently a company pays its bills. It is calculated by dividing the cost of goods sold (COGS) by the average accounts payable during a specific period. A high APT ratio indicates that a company is paying its bills quickly, which can improve its cash flow and relationships with suppliers. A low APT ratio could indicate that a company is taking too long to pay its bills, which could damage its relationships with suppliers and lead to late payment penalties. The article also provides tips on how to improve your APT ratio, such as negotiating longer payment terms with suppliers and automating accounts payable processes.

Here are the key points:

The ideal accounts payable turnover ratio (APT) is a financial metric that measures how efficiently a company pays its bills.
A high APT ratio is a good indicator of financial health, while a low APT ratio could be a sign of trouble.
The APT ratio is calculated by dividing the cost of goods sold (COGS) by the average accounts payable during a specific period.
There are a number of ways to improve your APT ratio, such as negotiating longer payment terms with suppliers and automating accounts payable processes.

This highlights the importance of tracking key metrics with financial ratios being one of the most important metrics to track. Financial ratios such as Accounts Payable Turnover Ratio are an eye-opener with regards to the financial stability and well-being of a business. Also known as accounting ratios, these compare two-line items in the financial statement (income statement, cash flow statement, balance sheet) of an organization. Accounting ratios can be classified into below three categories:

1. Debt Ratios: These ratios measure the debt of a company in relation to various other figures and is helpful in assessing a company’s capacity to pay-off its debts in the long run.  

2. Liquidity Ratios: Also known as accounts payable turnover ratio, consider a company’s current assets and liabilities and measure the liquidity or ability to pay short-term debts. Keeping a tab on this ratio is important as a low liquidity ratio could be an indicator of a business heading towards bankruptcy or closure. 

3. Profitability Ratios: As the name suggests these accounts payable turnover ratio calculation, a company’s profit generation capabilities. Earnings per share, return on equity, and Gross margin are all examples of profitability ratios. 

It’s imperative to track financial ratios on a quarterly basis as it gives a true picture of the cash flow and can be helpful in taking proactive measures to prevent any disruptions and instances of bankruptcy. Given the importance of financial liquidity for a business, we will focus on accounts payable turnover ratio and its importance for a business. 

What is Accounts Payable Turnover Ratio?

ideal Accounts payable turnover ratio is an indicator of how efficiently a business is managing its accounts payable function. It tracks the number of times the accounts payable has released payments to its creditors/vendors in a given time-period. Constantly monitoring the accounts payable turnover ratio can help identify any instances of delays in releasing payments and take corrective action. 

On the other hand, a high accounts payable turnover ratio is an indicator of good liquidity and an efficiently managed cash flow. It also enables a business to establish a dependable image in the market and they can leverage this to negotiate good credit terms with its suppliers. Let’s look at how to calculate accounts payable turnover ratio (accounts payable turnover ratio calculation). 

Accounts Payable Turnover Ratio Calculation 

accounts payable turnover ratio formula 

Accounts payable turnover ratio = Total net credit purchase from suppliers in a period  /  Average accounts payable balance for the period  

1. Accounts Payable Turnover Ratio Calculation – Calculating Net Credit Purchases 

Net credit purchases = Total credit purchase in a period – Good purchased on credit returned 

Companies can choose to do this task manually but its prone to errors like missed entries and manual oversight. By investing in an Accounts Payable Automation Software such as Zycus having e-invoicing, Three-way Matching, and report generation capabilities organizations can generate automated or customized on-demand reports of total credit purchase from suppliers for a particular period. 

2. Average Accounts Payable Turnover Ratio Circulation 

In your balance sheet look at your accounts payable balance under current liabilities at the starting of the quarter and the ending of the quarter. Here is the average accounts payable turnover ratio formula. 

Average accounts payable = (Opening AP balance + Closing AP balance) / 2 

Example of ideal accounts payable turnover ratio calculation  

Total net credit purchase as for the period April 2022 to June 2022 INR 20,00,000 
Accounts payable balance as on 1st April 2022INR 10,00,000 
Accounts payable balance as on 30th June 2022INR 8,00,000 
Average accounts payable balance = 18,00,000/2 INR 9,00,000 
AP or Accounts Payable Turnover Ratio20,00,000/9,00,000 
 2.22 

3. Ideal Accounts Payable Turnover Ratio vs Days Payable Outstanding (DPO) 

DPO refers to the number of days a business takes to clear outstanding vendor invoices for purchases made on credit. DPO can be calculated for a year, quarter, or a month using the below accounts payable turnover ratio formula: 

Annual: 365 days / AP turnover ratio
Quarter:  90 days /  AP turnover ratio
Monthly: 30 days / AP turnover ratio

Using the above example, we can derive the DPO for a quarter as below: 

DPO = 90/2.22 = 40.5 days 

It’s a good practice to calculate DPO for ensuring a healthy ideal accounts payable turnover ratio and an overall efficient accounts payable process. While DPO gives an insight on the average number of days an organization takes to clear vendor outstanding, accounts payable turnover ratio gives a holistic view of the overall cash management and liquidity. Both metrics are equally important to track.  

What is the Accounts Payable Turnover Ratio Industry Average?

The industry average varies from one industry to another however, it is recommended to maintain an accounts payable turnover ratio between 8 and 10.  Having said that the industry average and considerations for food industry or fast fashion will be different from perhaps the real-estate/construction industry.  

Also, one must understand that though accounts payable turnover ratio is a good indicator of how efficiently vendor invoices are being cleared, it does not necessarily reflect on what is happening behind the scenes. A high accounts payable turnover ratio does indicate that a business has a healthy cash-flow but it does not give insights on the reasons. 

A high accounts payable turnover ratio could be a result of simplified workflows as an outcome of using AP Automation Software which enables faster processing of invoices, fast resolution of vendor disputes, Dynamic Discounting, and better renegotiated payment terms with vendors. 

A low accounts payable turnover ratio though may indicate a poor cash flow it could be a result of better terms negotiated with suppliers. The best way to determine whether or not you are maintaining a healthy accounts payable turnover ratio is to assess and compare  your financial data with peers and competitors within your industry. 

Why is Accounts Payable Turnover Ratio Important?

Keeping a track of your accounts payable turnover ratio is important as it provides insights on: 

1. Cash Flow Management

A high turnover is an indicator of timely payments, good supplier relations, healthy credit terms, and efficient cash flow management. A low ratio indicates shortage of funds or holding on to cash for longer periods resulting in higher vendor disputes and bad reputation of the company. Efficient cash flow also  indicates that a business can meet all its financial obligations comfortably and is not accumulating any debts. 

2. Working Capital Management

A high turnover indicates availability of adequate working capital for seamless day to day operations and probably even availability of surplus cash to reinvest or repay debts. A low turnover means its time to take adequate measures to avoid possible closure of business. 

3. Operational Efficiency

Tracking the accounts payable turnover ratio also gives insights on the efficiency of the entire procure-to-pay cycle. 

4. Benchmarking

ideal Accounts payable turnover ratio enables a business to compare its performance with the competition and reflect on where it stands as per the industry benchmark. It also helps a business identify areas that require improvements. 

5. Investor and Supplier Confidence

A high turnover ratio helps a business establish an image of a good pay master and bolster itself as a financially sound organization. This helps instil confidence in investors and suppliers both. 

6. Business Strategy

A regular accounts payable turnover ratio calculation helps identify the trend or pattern (increasing ratio means a healthy cash flow, decline indicating potential cash flow problems). By studying the pattern one can make amends to the existing business strategy. 

How to Improve Accounts Payable Turnover Ratio?

By now it’s well established that accounts payable turnover ratio it is important for managing an efficient cash flow, healthy vendor relationships, and getting insights on a company’s liquidity position. It is therefore imperative for any business to optimize their accounts payable turnover ratio and they can do so by adapting the following best practices: 

1. Optimizing Cash Flow 

Optimizing the cash flow helps pay bills and vendors prior to the due dates and get discounts for early payments. It also leaves the business with surplus cash flow to pay-off debts and reinvest in the business often. One way to optimize cash flow is to reassess your accounts receivable processes and make necessary changes in your collections processes if needed. 

2. Clear Vendor Dues Early 

By paying vendors before the due date a business can save a significant amount of money in the form of discounts received by the vendors for making payments early. 

Invest in an AP Automation Software 

One of the biggest challenge businesses faces is manual processes. Paper based manual AP processes mean a long payment cycle starting with invoices arriving in a mailbox, accounting team checking and auditing them, manually writing cheques, getting them signed from concerned authorities and so on and so forth.

In short, an endless cycle fraught with many errors and untraced transactions – a perfect recipe for disaster.  However, by investing in a paperless Accounts Payable Automation Software like Zycus, can automate the entire process from raising a PO (purchase order) to releasing payments.

This not only expedites the entire process but also ensures invoices are paid on time, early where possible to leverage any discounts, and transparent and strengthened supplier relationships. With access to reports and analytics, businesses get a holistic view of their expenses, cash-flow, and outstanding payments.  

Achieve your Ideal Accounts Payable Turnover Ratio with Zycus 

A low accounts payable turnover ratio may be an indication of a company in financial distress or a smart strategy to improve cash flow by delaying payments. A high ratio may indicate a strong liquidity status. Whatever the case, investing in an AP automation software simplifies the AP function and makes it agile. It also simplifies the tracking and accounts payable turnover ratio calculation. 

Zycus offers an AI-led AP automation software that helps reduce invoice processing times by a whopping 75%. The software harnesses the power of the Merlin AI Suite to automate all tasks from invoice generation to payments to supplier communication and everything in between. Book a demo today and set new industry benchmarks with respect to ideal accounts payable turnover ratio.

Related Read: 

  1. Top 7 reasons to Digitize Accounts Payable
  2. What is Dynamic Discounting?
  3. Measuring Your Accounts Payable Effectively: Operational Metrics
  4. Accounts Payable Automation Software Datasheet

 

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Swagata Kumar having over 13 years of experience as a seasoned Product Marketing leader, developing and implementing effective Go to Market strategies for high growth B2B SaaS Products and Technology solutions. She bring with an unique and strong blend of experience across Product Marketing, Go to Market, Customer Marketing, Business Strategy, Sales Enablement and Business Development in B2B SaaS. Throughout her rewarding career, she have closely collaborated with sales leaders in diverse markets, enabling me to design and implement impactful campaigns that have significantly contributed to business revenue growth and market share expansion. As a result, She have developed an in-depth understanding of revenue-driven marketing strategies for B2B SaaS products in the US and EMEA regions. She expertise encompasses Product Marketing, Product Positioning and Messaging, GTM Strategy, Cross Functional Leadership, New Product Launches, Sales Enablement, Product Evangelization, Customer Marketing, Market and Industry Research, Competitive Benchmarking, Content Marketing,
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