There are several fundamental principles involved with this ratio and as a business entrepreneur you should gain a full understanding of the formula. It is easy to manipulate the results and there is proper application of the formula in business. This paper is designed to enlighten the reader to the formula’s benefits and drawbacks.
THE UNDERLYING GOAL OF THE ACCOUNTS PAYABLE TURNOVER RATE IS TO MEASURE THE FREQUENCY (ABILITY) OF THE BUSINESS TO PAY ITS BILLS IN A TIMELY MANNER.
Accounts Payable Turnover Rate Formula
Academia instructs students with the following as the accounts payable turnover rate (ratio) formula:
Accounts Payable Turnover Rate = Sales/Average Accounts Payable Balance
The rate is annual value and is the average of the twelve months ending balances. Take the sum total of accounts payable and divided by 12 for the average. Below is an illustration.
Fenner’s Auto Parts
Fenner’s sells auto parts for foreign cars. The following is the store’s accounts payable ending balance for 2015 by month and the final average.
Divide by 12
Average Balance $134,028
Fenner’s sales for 2015 were $2.6 Million; therefore the accounts payable turnover rate is:
19.40 equates to an average cycle of 18.5 days (360 days/19.4). This is very good. If sales (numerator) increases without a change in accounts payable average then the ratio will also increase. At $3.6 Million in sales without an increase in the average payables balance the rate is 26.9 or a cycle period of 13.4 days. Notice that as the ratio increases, the cycle period decreases.
So this relationship between sales and the average accounts payable balance determines the ability of the company to pay its bills in a timely fashion. If the average balance increases for payables and there is no change in sales, it symbolizes a slowing down of paying bills in a timely manner, i.e. the rate decreases increasing the average number of days to pay a bill.
Remember the key to this ratio is that it is used to ‘Measure the ability to pay bills in a timely manner’. Is it a true and absolute measurement device? Let’s find out.
One of the basic business principles is called substitution. For this formula it is essentially shifting the financial obligation to another venue. For accounts payable it is a matter of transferring the financial obligation by using a different type of current liability. Look at the following types of current liabilities :
A simple draw on a line of credit and then using those proceeds (cash) to pay down accounts payable is effectively shifting the accounts payable to the line of credit. The A/P average decreases, increasing the turn ratio. So an outside reader would be misled as to the true ability of the company to pay its bills in a timely manner.
Another aspect of this same principle is using credit cards to purchase necessary materials and supplies for sales. This reduces the average accounts payable and thus increases the turn rate.
What is interesting is that there are many different methods to manipulate the results.
Substitution is the number one method used to manipulate the formula. In small business, the lack of working capital [link to article – Working Capital] or the extended working capital cycle forces the owner to delay or slow pay accounts payable. After extended periods of time with slow pay and the corresponding stress (vendor phone calls, extra notices, disgruntled suppliers) small business owners shift current liabilities to long-term notes via loans. Initially the shifting is within current liabilities; once the credit is fully utilized, owners shift to longer term types of liabilities freeing up short-term accounts for further use.
The above substitution method affects the denominator. Manipulation also occurs with the numerator.
The fundamental underlying theory of the accounts payable turnover rate (ratio) is based on an outdated retail model. In that model, accounts payable are used for purchasing products to sell. The customer pays with cash and the formula has a pure relationship. But modern businesses no longer function like this. The more common forms of sales include exit pay (cash, debit/credit at the register), customer accounts, long-term revolving charge accounts and third-party financing. More importantly, sales in modern times have more service based orientation sources and not product sources. Almost everything sold includes warranties or service contracts. Therefore the mix of sales is diverse and often not purely related to accounts payable. Look at the following example:
Grafton Lawn Equipment
Grafton sells and services yard equipment including lawn mowers, small tractors, light duty construction equipment and small fuel powered tools. As the customer base broadened over many years the sales mix continuously shifted towards service. The mix is almost 60/40 with service dominating sales.
Accounts payable is strictly used for suppliers of equipment. Over the last four years, the store has averaged $70,000 of accounts payable. The sales mix has changed from product to service per the following schedule:
Technically, using the standard formula the turnover rate is continuously improving per this schedule:
This would indicate that Grafton is doing extremely well in paying its bills in an expeditious manner. But here is the reality, remember product sales were constant over this time and the payables are strictly related to products purchased for equipment sales.
Accounts Payable Turnover Rate = $1,080,000/$70,000
Accounts Payable Turnover Rate = 15.43 for all four years
Another key to the numerator is level sales with similar markups throughout the entire year. Many businesses, especially small businesses, concentrate their sales base on seasonal income. Think of the local hardware store (Ace, True Value etc.) that depend on sales related to spring items for the home. Other retailers place high reliance on Christmas to bring in the money. How does seasonal sales affect the payables turnover rate?
If the relationship is pure (retail and equal markup on all products) as explained earlier, the average payables turnover rate will remain constant. Look at the following schedule and note the seasonal increase in sales in the springtime. This is the monthly turnover rate:
In this store’s case the gross margin percentage is most likely 50% (can be different, but to prove the point 50% is the assumed percentage). If seasonal items have a different markup, higher or lower than normal, it can greatly affect the ratio. Assume the same sales, but markup for the marginal seasonal items in March, April and May is double (which cuts in half the marginal increase in the accounts payable average). Look at this comparable schedule:
So seasonal sales can affect the turnover rate if the markup is different which is usually true. Another factor having a bearing on this turnover rate is the lag time between delivery of the retail product and the actual sale of the product.
Think about the candy manufacturer/retailer for chocolates. The company buys the raw chocolate, sugar and cremes well in advance of the respective holiday sales period. The sales for the product are generally intense just prior to the holiday. However the average accounts payable increased significantly several months prior to the sales period. Therefore the average accounts payable (denominator) increases without a corresponding increase in sales. The turnover rate goes down and can be interpreted as a poor indicator of the ability to pay the bills. The exact opposite happens in the month of robust sales and the turnover rate looks great.
Based on the above it appears easy to manipulate and misinterpret the payables turnover rate. So how does a business entrepreneur properly apply the formula?
Proper Application of the Accounts Payable Turnover Rate
The first rule of thumb is to only use this formula in business with sales in excess of $10 Million per year. This large sales volume minimizes mix and seasonal effects on the formula. In addition, limit the formula to business operations that have a pure or very strong retail to payables relationship. Service based operations should ignore or not use this particular activity ratio.
So if it is inadvisable to use this ratio in small business, what can the owner or investor use as a tool to measure the ability of the business to pay its bills on time?
There are several alternatives that inform readers of financial information about the ability of a small business to pay its bills. They are as follows:
Current Liabilities Turnover Rate
This is very similar to the accounts payable turnover rate except now all the current liabilities are included in the average. This eliminates the substitution method (shifting of debt to other current liabilities), sales mix and other manipulation tactics. In addition it is really what an interested party wants to know – how often does the business pay its bills, ALL BILLS.
Working Capital Growth Trend Line
The positive difference of current assets over current liabilities is called working capital. Ultimately working capital should increase in incremental steps over time. This is the trend line. If the line is increasing (positive) then in the long run cash is available to pay the bills in a more timely manner. There is a complete series related to working capital available. If interested read:
WORKING CAPITAL – Introduction to the business concept.
WORKING CAPITAL CYCLE – Different time frames to complete the cycle are explained.
WORKING CAPITAL MANAGEMENT – PART III
Cash Flow From Operations
This is the best indicator of the ability to pay bills in a timely manner. Positive cash flow from operations indicates an increasing cash balance (in most cases); therefore more funds are available to reduce current liabilities. Cash flow from operations takes into consideration profit, gross working capital changes and all current liability changes with their respective balances. As cash flow increases the cash balance is available to reduce current liability balances.
Good Financial Management
Overall, good financial management provides the greatest latitude in addressing consistency in paying all liabilities. Finance managers look at future commitments to deal with solvency [link to article – Bankruptcy and Insolvency What are the Differences] of the business. Any capital (working capital) outlays for new equipment or to fund growth is dealt with after addressing short-term liabilities. Since most small businesses lack a finance manager, the owner typically assumes this role. Most novice business entrepreneurs focus on funding growth and not the day-to-day operations. This is a mistake. Focus on reducing short-term (current) liabilities first and once working capital is adequate; growth is considered.
Summary – Accounts Payable Turnover Rate
The accounts payable turnover rate is an activity ratio measuring the ability of a company to pay its bills in a timely manner. The ratio is an indicator of how frequently in one full accounting cycle (fiscal year) the accounts payable balance is paid. The higher the value the more frequently bills are remitted. The formula is:
Accounts Payable Turnover Rate (Ratio) = Sales/Average Accounts Payable Balance
The formula is of little value in business operations with less than $10 Million per year in sales. This is because it is easily manipulated with either the numerator or denominator. As volume increases the manipulation factors are mitigated. In small business the best gauges of a company’s ability to pay its bills in a timely manner include cash flow from operations, good finance management and an increasing working capital growth trend line. As a substitute to accounts payable turnover rate use total current liabilities turnover rate. ACT ON KNOWLEDGE.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you.