The accounts payable turnover ratio is a key metric for businesses to monitor. By taking a strategic approach and aligning your goals with the right actions, you can optimize your AP turnover ratio to improve your organization’s financial health. In this post, we will look at what the accounts payable turnover ratio is, what makes a good AP turnover ratio, and how to strategically approach your AP turnover ratio.
What is the Accounts Payable Turnover Ratio?
The accounts payable turnover ratio is a metric used to track a company’s short-term liquidity. This ratio measures how quickly a company pays its invoices and is a good indicator of the company’s financial health. AP teams often track their turnover ratios for investors or suppliers to show them that the company responsibly manages its finances.
How to Calculate the AP Turnover Ratio
There are a few different ways to calculate the AP turnover ratio. The first way is to divide the net credit purchases made during a period by the average accounts payable balance during that same period. For example, suppose your company had net credit purchases of $200,000 during the first quarter of the year, and during that same time period, the average daily AP balance was $32,000. Then the AP turnover ratio during that quarter would be:
AP turnover ratio = (net credit purchases)/(average AP balance) = $200,000/$32,000 = 6.25
This ratio may be rounded to the nearest whole number, and hence be reported as 6. This number represents the number of times accounts turned over during that period.
How to Optimize AP Turnover Ratio
There isn’t necessarily such a thing as a “good” or a “bad” AP turnover ratio. Whether you want to make your ratio higher or lower will depend on the size of your business and your overall goals.
By examining the formula, you can see that making payments quickly will raise a company’s AP turnover ratio, whereas slower payments will decrease the turnover ratio. Making quick payments can improve vendor relationships and may be a sign that your AP department is running efficiently. It can also mean you’re more likely to save money by taking advantage of early payment discounts. In contrast, a lower AP turnover ratio could mean you are making a prudent financial choice to maximize cash on hand by only making payments when they are due and not any sooner. That said, it could also indicate that you aren’t making payments on time, therefore putting vendor relationships at risk.
How your AP turnover ratio changes can also indicate financial health. For example, a decreasing AP turnover ratio means a company is taking longer and longer to make payments which can indicate financial distress whereas an increasing ratio could signal improvement. But, again, these aren’t hard and fast rules. A decreasing ratio could also mean efforts are being made to manage cash flow for an upcoming business expense or investment.
Although creditors often consider higher AP turnover ratios as a better signal of creditworthiness, a lower AP turnover ratio can also indicate optimal credit terms with suppliers. For example, if your company negotiates to make less frequent payments without any negative impact, then the turnover ratio will decrease for that reason alone. In fact, the more favorable credit terms your company negotiates, the lower your AP turnover ratio is likely to be.
If you want to determine if your AP turnover ratio is optimal or not, it’s a good idea to compare your numbers with peers in your industry. If you want to be perceived as being in good financial standing, then your AP turnover ratio should be in line with whatever is typical for your business size and sector.
Converting AP Turnover Ratio to DPO
The accounts payable turnover ratio can also be easily converted to another metric called days payable outstanding (DPO), which is a measure of the average number of days it takes to render payments to suppliers.
DPO is calculated by taking the number of days in the period and dividing it by the AP turnover ratio. In the above example where we calculated the AP turnover ratio for a company’s first quarter, the corresponding DPO calculation would use the fact that there are 90 days in the first fiscal quarter and be calculated as:
DPO = days in period/AP turnover ratio = 90/6.25 = 14.4
This means it took the AP department approximately 14 days to pay suppliers on average during the first quarter.
Taking a Strategic Look at AP Turnover Ratios
When you’re looking at your organization’s AP turnover ratio, it can be helpful to take a strategic view. For example, what are your organization’s goals? Are you trying to improve supplier relations or reduce costs? Once you know what your goal is, you can put together a plan to optimize the accounts payable turnover ratio to help achieve that goal. Each approach comes with pros and cons, so it’s important to weigh all the factors before making a decision. The most important thing is to ensure that whatever decision is made aligns with the organization’s overall goals.
For example, if saving money is your primary concern, there are a few approaches you can take. In some cases, paying vendors more quickly can lead to early payment discounts and also help avoid late fees. This can be done by consolidating multiple invoices into a single payment or automating payments so they are made as soon as invoices are received.
If you want to maximize cash on hand so that you have more funds to invest in growth or other projects, then negotiating longer payment terms and using automation tools to render payments at the latest possible date that doesn’t incur additional fees will help free up cash by maximizing your average daily balance.
Maintaining good supplier relations is another common priority. Firms looking to strengthen their vendor relationships find that paying invoices quickly is a sure-fire strategy. This could involve setting up a vendor portal where invoices and payments can be easily tracked or working with a select group of vendors to set up electronic payments.
AP turnover ratios can also be used in financial modeling to help forecast future cash needs. This is because they can help create balance sheet forecasts which require estimates of how long it will take to pay balances and how much cash the company may have on hand at any given time.
Measuring and monitoring important AP metrics is made easier with the right tools. MineralTree’s AP automation solution includes integrated analytics and interactive visualization tools providing comprehensive, real-time visibility into every aspect of the AP process, including vendors, purchase orders, invoices, and payments. Users have access to real-time dashboards to track metrics, such as invoice aging, discounts, rebates earned, payment mix, and more.
In fact, Simple Mills, a leading healthy snack provider recently gained access to powerful analytics by adopting the MineralTree platform. The company can now look into important metrics, including spend-by-vendor, which allowed them to model various business scenarios. They can view what happens if they extend payment terms or ask for early pay discounts with certain suppliers. Insights into payment data offered by MineralTree analytics have led to improved business decision-making for the company.
Learn more about how MineralTree’s platform and analytics solutions can help your AP team today by requesting a free demo.