What is Accounts Payables Turnover?
The Accounts Payables Turnover ratio measures how often a company repays creditors such as suppliers on average to fulfill its outstanding payment obligations.
How to Calculate Payables Turnover Ratio?
As part of the normal course of business, companies are often provided short-term lines of credit from creditors, namely suppliers.
The accounts payable turnover, or “payables turnover”, is a ratio used to evaluate how quickly a company repaid those that offered them a line of credit, i.e. the frequency at which a company pays off its accounts payable balance.
Calculating the accounts payable ratio consists of dividing a company’s total supplier credit purchases by its average accounts payable balance.
The “Supplier Credit Purchases” refers to the total amount spent ordering from suppliers.
The total supplier purchase amount should ideally only consist of credit purchases, but the gross purchases from suppliers can be used if the full payment details are not readily available.
Moreover, the “Average Accounts Payable” equals the sum of the beginning of period and end of period carrying balances, divided by two.
Payables Turnover Ratio Formula
The formula for calculating the accounts payable turnover is as follows.
In short, the A/P turnover answers:
- “How often does the company pay off its invoices per year on average?”
For example, if a company’s A/P turnover is 2.0x, then this means it pays off all of its outstanding invoices every six months on average, i.e. twice per year.
So the higher the ratio, the more frequently a company’s invoices owed to suppliers are fulfilled.
Payables Turnover Ratio vs. Days Payable Outstanding (DPO)
The days payable outstanding (DPO) metric is closely related to the accounts payable turnover ratio.
DPO counts the average number of days it takes a company to pay off its outstanding supplier invoices for purchases made on credit.
The more a supplier relies on a customer, the more negotiating leverage the buyer holds – which is reflected by a higher DPO and lower A/P turnover.
The A/P turnover ratio and the DPO are often a proxy for determining the bargaining power of a specific company (i.e. their relationship with their suppliers).
- High A/P Turnover and Low DPO ➝ Low Bargaining Leverage and Less Free Cash Flow (FCF)
- Low A/P Turnover and High DPO ➝ High Bargaining Leverage and More Free Cash Flow (FCF)
Companies like Amazon and Walmart extend their payables outstanding for that reason, i.e. their branding, reputation, and order volume (and size) can all be leveraged to defer supplier payments.
From the date when the credit purchase was made to the date that the company actually paid the supplier in cash, the cash remains in the possession of the buyer, who has the discretion to spend that cash in the meantime (e.g. to reinvest into operations, for capital expenditures).
What is a Good Payables Turnover Ratio?
The rules for interpreting the accounts payable turnover ratio are less straightforward.
For instance, if a company’s accounts receivable turnover is far above that of its peers, there could be a reasonable explanation. However, it is rarely a positive sign, i.e. it typically implies the company is inefficient in its ability to collect cash payments from customers.
But in the case of the A/P turnover, whether a company’s high or low turnover ratio should be interpreted positively or negatively depends entirely on the underlying cause.
- Lower Payables Turnover → If a company’s A/P turnover is on the lower end because of its buyer power, i.e. the ability of a customer to reduce prices and negotiate favorable terms, which is delaying how quickly suppliers must be repaid in this case.
- Higher Payables Turnover → Conversely, a company’s A/P turnover could also be low not because of its negotiating leverage but from its inability to repay suppliers even if it wanted to.
In the latter scenario, the company is facing a shortage in liquidity (i.e. low cash on hand), a red flag that could potentially result in the company being in urgent need of restructuring or filing for bankruptcy protection.
Payables Turnover Ratio Calculator
We’ll now move to a modeling exercise, which you can access by filling out the form below.
1. Payables Turnover Ratio Calculation Example
Suppose a company spent $1,000,000 on orders from suppliers in the most recent period (Year 1).
If the company’s accounts payable balance in the prior year was $225,000 and then $275,000 at the end of Year 1, we can calculate the average accounts payable balance as $250,000.
Using those assumptions, we can calculate the accounts payable turnover by dividing the Year 1 supplier purchases amount by the average accounts payable balance.
- Accounts Payable Turnover = $1,000,000 ÷ $250,000 = 4.0x
The company’s A/P turned four times in Year 1, meaning that its suppliers were repaid each quarter on average.
2. Payables Turnover Ratio in DPO Calculation
Given the A/P turnover ratio of 4.0x, we will now calculate the days payable outstanding (DPO) – or “accounts payable turnover in days” – from that starting point.
If we divide the number of days in a year by the number of turns (4.0x), we arrive at ~91 days.
The 91 days represents the approximate number of days on average that a company’s invoices remain outstanding before being paid in full.
- Days Payable Outstanding (DPO) = 365 ÷ 4.0x = 91 Days