Many companies don’t know or understand the importance of ensuring an ideal accounts payable turnover. It is actually a critical variable for managing cash flow, so review it carefully every quarter.
Every business needs to formulate a strategy for managing cash flow, which requires them to pay close attention to their accounts payable transactions. The underlying goal is to determine the best time to make payments to creditors to always have sufficient cash on hand. In other words, business owners need to determine their ideal accounts payable turnover - analyze their accounts payable turnover and consider either making payments earlier or delaying them.
Accounts payable turnover is a financial ratio that assesses the average time it takes for a company to pay off its creditors. The metric is very important for managing cash flow and is calculated with the following formula:
Accounts payable turnover = Total purchases / Average accounts payable balance
The following formulas are used to calculate the total purchases and average accounts payable balance:
Total purchases = Cost of sales + Inventory balance at end of period – Inventory balance at beginning of period
Average accounts payable = (Accounts payable balance at the beginning of period + Accounts payable balance at the end of period)/2
It only takes a few minutes to calculate your accounts payable turnover ratio, provided you are up-to-date with your bookkeeping. However, analyzing this metric to make more informed cash management decisions is slightly more complicated. The following section provides some important insights.
Is it better to increase or decrease your accounts payable turnover ratio? Unfortunately, it is difficult to answer that question, because both approaches could lead to cash flow problems if utilized improperly.
If your accounts payable turnover is too high, then you may be paying bills too quickly and you may not have sufficient cash on hand to meet future bills. However, low accounts payable turnover ratios can indicate that you are delaying your payments too long and may have difficulty raising the cash needed. Here are some factors to consider when paying accounts payable:
Accounts receivable cycles and supplier contracts vary by industry, so it is impossible to determine the best accounts payable turnover. However, it is important to study the metric within the context of your own business. After using this metric to perform a cost-benefit analysis, you may decide to start paying your bills earlier or later.
If you need help to determine the ideal accounts payable turnover for your business, please do not hesitate to ask us.
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