Ideal Accounts Payable Turnover

What is the ideal accounts payable turnover? 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.

What is Accounts Payable Turnover?

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.

What Does Your Ideal Accounts Payable Turnover Ratio Mean?

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:

• Supplier discounts. Many suppliers offer discounts to customers for early payments. For example, a supplier may offer terms of 2/10, which indicates that customers receive a 2% discount for payments made within 10 days of receipt of the goods or services. If the company takes an average of 11 or more days to make payments, then it may be missing some valuable discounts.
• Cost of borrowing cash. Borrowing cash will be expensive if your lender charges high interest rates for short-term loans. It is best to avoid borrowing cash except for emergencies.
• Accounts receivable cycles. Your accounts receivable cycles also play an important role in managing your accounts payable. Companies that receive payments infrequently may need to extend their accounts payable turnover ratio to ensure they have enough cash on hand to deal with unexpected expenses that may arise.
• Relationship with suppliers. Maintaining good relationships with suppliers is an important priority for most businesses. A high accounts payable turnover ratio may indicate that you are either late making payments or paying them as close to the due date as possible. Your suppliers probably won’t be upset if you wait until the last minute to receive payment, but they will appreciate early payments. Some suppliers offer more favorable terms to customers that regularly make payments early, so keep this in mind while analyzing your accounts payable turnover rate.

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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