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
Creditors may get an idea of the company’s short-term liquidity and, to some degree, its creditworthiness by looking at the accounts payable turnover ratio. If the percentage is high, it means that timely payment is being paid to suppliers for purchases purchased on credit. There are a few possible explanations for such a high number: either the firm is trying to take advantage of early payment discounts or it is actively striving to enhance its credit rating. Another possibility is that the company’s suppliers are demanding prompt payments.
A low ratio suggests that buyers on credit are not paying their suppliers as quickly as they should be. This might be the result of attractive lending conditions, or it could be an indication of issues with cash flow and, therefore, a deteriorating financial state. Even while a falling ratio can suggest that a firm is experiencing financial difficulties, there is no guarantee that this is the case. It’s possible that the firm has successfully negotiated improved payment conditions, which enable it to make payments less often without incurring any penalties. If so, this would be a very positive development.
The credit conditions that are established by suppliers have an impact on the accounts payable turnover ratio. Companies that have more favourable loan conditions than their competitors, for instance, often report a considerably lower ratio. Because of their greater purchasing power, large corporations are able to negotiate more favourable credit conditions, which results in a lower accounts payable turnover ratio.
Although a high accounts payable turnover ratio is generally desirable to creditors as a signal of creditworthiness, companies should typically take advantage of the credit terms extended by suppliers because doing so will assist the company in maintaining a comfortable cash flow position. This is the case despite the fact that a high accounts payable turnover ratio is generally desirable to creditors as a signal of creditworthiness.
As is the case with the majority of financial measures, the turnover ratio of a firm is best analysed in comparison to other organisations operating in the same sector. For instance, if the majority of a firm’s rivals have a ratio of at least four, then the fact that the company in question only has a payables turnover ratio of two is cause for increased worry.