Creditors turnover Ratio

Accounts payable turnover ratio (also known as creditors turnover ratio or creditors’ velocity) is computed by dividing the net credit purchases by average accounts payable. It measures the number of times, on average, the accounts payable are paid during a period.  Like receivables turnover ratio, it is expressed in times.

Formula:

Accounts payable turnover Ratio = Net credit purchases / Average accounts payable

In above formula, numerator includes only credit purchases. But if credit purchases are not known, the total net purchases should be used.

Average accounts payable are computed by adding opening and closing balances of accounts payable (including notes payable) and dividing by two. If opening balance of accounts payable is not given, the closing balance (including notes payable) should be used.

Analysis

Since the accounts payable turnover ratio indicates how quickly a company pays off its vendors, it is used by supplies and creditors to help decide whether or not to grant credit to a business. As with most liquidity ratios, a higher ratio is almost always more favorable than a lower ratio.

A higher ratio shows suppliers and creditors that the company pays its bills frequently and regularly. It also implies that new vendors will get paid back quickly. A high turnover ratio can be used to negotiate favorable credit terms in the future.

Interpretation of Accounts Payable Turnover Ratio

The accounts payable turnover ratio indicates to creditors the short-term liquidity and, to that extent, the creditworthiness of the company. A high ratio indicates prompt payment is being made to suppliers for purchases on credit. A high number may be due to suppliers demanding quick payments, or it may indicate that the company is seeking to take advantage of early payment discounts or actively working to improve its credit rating.

A low ratio indicates slow payment to suppliers for purchases on credit. This may be due to favorable credit terms, or it may signal cash flow problems and hence, a worsening financial condition. While a decreasing ratio could indicate a company in financial distress, that may not necessarily be the case. It might be that the company has successfully managed to negotiate better payment terms which allow it to make payments less frequently, without any penalty.

The accounts payable turnover ratio depends on the credit terms set by suppliers. For example, companies that enjoy favorable credit terms usually report a relatively lower ratio. Large companies with bargaining power are able to secure better credit terms, resulting in a lower accounts payable turnover ratio (source).

Although a high accounts payable turnover ratio is generally desirable to creditors as signaling creditworthiness, companies should usually take advantage of the credit terms extended by suppliers, as doing so will help the company maintain a comfortable cash flow position.

As with most financial metrics, a company’s turnover ratio is best examined relative to similar companies in its industry. For example, a company’s payables turnover ratio of two will be more concerning if virtually all of its competitors have a ratio of at least four.