How To Improve Your AP Turnover Ratio and Create Stronger Supplier Relationships
Business owners understand that maintaining healthy supplier relationships is critical to business success. One of the keys to staying on good terms with your suppliers is having a high accounts payable (AP) turnover ratio, one of the most important financial ratios businesses use in forecasting and budgeting.
Your AP turnover ratio can also have a significant effect on your cash flow, which influences your ability to pay your bills and still be able to grow your business and remain competitive.
By optimizing your accounts payable turnover ratio, you’ll help keep your company financially healthy and protect long-term relationships with your creditors. It’s a lot easier than you might think.
What is the Accounts Payable Turnover Ratio Definition?
Also known as the creditors’ turnover ratio, the accounts payable turnover ratio is a critical metric that signals whether a company is paying for supplier purchases in a timely fashion.
What is Accounts Payable (AP) Turnover Ratio?
Accounting professionals in finance departments use the AP turnover ratio on a company’s balance sheet as a key liquidity and cash flow management indicator.
For example, a low or declining turnover ratio suggests that a company struggles to meet its financial obligations. Steady or rising turnover ratios indicate that the company is financially healthier and can qualify for increased lines of credit that can be used to fuel innovation and growth.
Companies that rely on lines of credit for cash usually need to maintain a high AP turnover ratio because many lenders and suppliers use this metric to assess the risk they take by extending the company credit. If the company has a low AP ratio, its ability to secure credit can be negatively impacted.
How To Calculate Accounts Payable Turnover Ratio
The accounts payable turnover ratio is a value that defines a company’s liquidity. In essence, it suggests how quickly a company can pay its bills by comparing net credit purchases to the average accounts payable.
To calculate the AP turnover formula, you first need to calculate two other values, total net credit purchases and average accounts payable.
Here’s how you can determine those values:
- Total net credit purchases: To calculate this value, you subtract the starting inventory from the ending inventory and add that amount to the cost of sales. Companies that use accounts payable software or accounting software can automatically generate the total credit purchases with a few keystrokes.
- Average accounts payable: Determine this amount by adding the beginning and ending accounts payable balances for the desired period on your financial statement and dividing the total by two.
Once you have calculated these two amounts, use the accounts payable turnover ratio formula to calculate the final metric:
AP turnover ratio = Total net credit purchases from all suppliers during a time period ÷ Average accounts payable for the same period of time
This value will be the AP turnover ratio that accounting professionals use on their balance sheets to determine their company’s ability to pay its bills quickly.
An AP Turnover Ratio Example
Let’s look at an example of an AP turnover ratio calculated over one year.
To do this, let’s say Company A made $27 million in total net credit purchases during the year and finished the year with an open accounts payable balance of $4 million.
Now let’s apply those numbers to the above accounts payable turnover ratio formula:
$27 million ÷ $4 million = 6.75
Using this formula, we can determine Company A’s AP turnover ratio as 6.75. This means that Company A paid its average accounts payable balance 6.75 times during that accounting period.
AP Turnover in Days
Another important metric is the average number of days an invoice or other payable remains unpaid. This is called the accounts payable (AP) turnover ratio in days.
This value is calculated by simply dividing 365 by the AP turnover ratio:
AP turnover in days = 365 ÷ AP turnover ratio
Using the previous example for Company A, we can determine the AP turnover in days as follows:
AP Turnover in Days = 365 ÷ 6.75 = 54.07
This means that Company A took approximately 54.07 days to pay its suppliers and creditors during their fiscal year.
Interpretation & Analysis: What is a Good Accounts Payable Turnover Ratio?
So now that we’ve calculated Company A’s AP turnover ratio, what does it mean?
The accounts payable turnover ratio signals to creditors about a company’s short-term liquidity and, by extension, the company’s overall creditworthiness. A high ratio indicates that the company can make prompt payment to its creditors and suppliers for purchases made on credit. This could also mean that suppliers expect quick turnaround times on invoices.
A high accounts payable turnover ratio could also mean that the company is actively working to improve its credit rating by paying its invoices quickly or paying quickly to take advantage of early payment discounts to improve its cash flow.
Although it’s generally desirable to have a high accounts payable turnover ratio to indicate a reasonable credit risk, companies should also strive for balance by taking advantage of generous credit terms when suppliers extend them. This will help improve cash flow and may result in discounts on purchases.
A company with a low accounts payable turnover ratio may take longer to pay its suppliers for purchases made on credit. This metric could also indicate a company in financial distress. However, it might also mean that the company has successfully negotiated favourable payment terms that allow it to make payments with less frequency and without any penalties.
Large companies with significant bargaining power often have lower accounts payable turnover ratios because they can secure better payment terms. The lower ratio shouldn’t be the final word on whether the company is financially sound.
In other words, it’s essential to remember that a company’s accounts payable turnover ratio is often driven by the credit terms of its suppliers and not solely by the company’s ability to pay.
Also, as with many other financial metrics, a company’s accounts payable turnover ratio should be considered relative to comparable companies in their industry. For example, a company’s payable ratio of 3 will raise a red flag if most of its competitors have a ratio of 7.
What is a Normal AP Ratio?
This is a very common question to which there is no easy answer. This metric will vary across different industries and requires benchmarking against similar companies in the same sector to gauge how a company is performing.
High AP Ratio Analysis
To summarize, a high accounts payable turnover ratio signals that a company:
- Can pay its bills frequently
- Is in a position to negotiate favorable credit terms
- Is a reasonable risk to make more purchases on credit
These are all significant indicators of a healthy business, but a high accounts payable turnover ratio that continues to climb over time may also suggest that the company isn’t managing its cash flow properly.
Low AP Ratio Analysis
A company with a low accounts payable turnover ratio may be:
- Struggling to pay its bills on time
- Suffering from cash flow problems
- A high risk for extended credit
As previously mentioned, this may also indicate a company that has negotiated favourable payment terms and is preserving its cash flow by paying bills over a longer period.
Ways To Improve Your AP Turnover Ratio
Increasing your accounts payable turnover ratio is critical to your company’s financial health. It also helps you maintain strong supplier relationships, manage your cash flow, and negotiate favourable credit terms. Fortunately, the solution to improving your ratio is easier and more cost-effective than you might think.
AP automation offers a seamless, streamlined way to identify cash flow issues, solve bottlenecks, errors, and duplication in your invoice processing system, and ensure your payments are made on time. Automating your AP system can also lower your cost per invoice, reduce disputes, support compliance, and improve supplier relationships.
All of these factors will help improve your accounts payable turnover ratio.
Optimize Your Accounts Payable with Ash Conversions International
For over 40 years, ACI has specialized in transforming how companies run their business processes with efficient, cost-effective solutions. ACI offers customized AP automated solutions that increase efficiency, streamline operations, save money, and improve your accounts payable turnover ratio.
Here’s how our AP Automation solution works to make invoice processing easier for your accounts payable department and more cost-effective:
- All hardcopy and digital invoices are captured into the AP Automation system
- Optical character recognition (OCR) accurately scans and captures relevant data from the invoices
- Information such as vendor name, invoice amount, product and service details, and more are stored as data points
- Invoice information can be retrieved, reviewed, and approved for payment online by authorized end-users
Invoice images and data files are stored in our cloud-based document management platform called FileManager™, allowing real-time visibility into your AP system through a secure login from anywhere in the world.
Our AP Assistant™ tool also offers the power of machine learning that adds an extra layer of artificial intelligence with every scanned and processed invoice. This feature helps provide better invoice classification and more accurate data validation, leading to fewer exceptions and more touchless invoice approvals in the future.
Click the button below and contact us today to learn more about how ACI’s invoice imaging and AP Automation solutions and services can help improve your accounts payable turnover ratio and make your business more profitable.
