Managing accounts payable is critical for any business to maintain healthy cash flow and vendor relationships. Financial ratios are essential tools that help companies evaluate their financial performance, including their ability to manage accounts payable effectively. In this article, we will discuss some of the most important financial ratios used to evaluate accounts payable performance, such as:
- The accounts payable turnover ratio
- The days’ payable outstanding ratio, and
- The current ratio – a company’s most crucial liquidity ratio.
We will explore the interpretation of these ratios regarding a company’s financial health and the best practices AP service organizations use to improve AP ratios.
What is accounts payable in ratio analysis?
Accounts payable is a liability representing the amount a company owes to its suppliers for goods or services received on credit. It is a critical component of the current liabilities in financial statements. It is used in financial ratio analysis to assess a company’s liquidity and ability to meet short-term obligations.
What are 3 key AP financial ratios?
Three key financial ratios for accounts payable include:
- The days’ payable outstanding ratio (AP balance x 365 / annual COGS)
- The current ratio (current assets / current liabilities)
- The accounts payable turnover ratio (Total purchases / Avg. AP)
The Days Payable Outstanding Ratio
The days’ payable outstanding ratio shows the average number of days it takes for a company to pay its suppliers. Generally, a DPO ratio of 30-40 days is reasonable for most businesses. However, some industries, such as retail or healthcare, may have lower DPO ratios due to their payment policies or supplier relationships.
The Current Ratio
This liquidity ratio compares a company’s current assets to its current liabilities and indicates its ability to meet short-term obligations. Generally, a current ratio of 1.5 to 2.0 is healthy and means a company has enough current assets to cover its current liabilities, including accounts payable. Only the company’s balance sheet is needed to calculate this ratio.
The Accounts Payable Turnover Ratio
The accounts payable turnover ratio measures how quickly a company pays off its suppliers. A turnover ratio of 10-12 times per year is considered healthy for most businesses. However, specific industries, such as retail, may have higher APTRs due to their frequent purchases and high supplier turnover.
Is a high AP turnover ratio good?
A high accounts payable turnover indicates that a company is paying off its suppliers quickly. This can be a sign of good working capital management and a strong balance sheet, attracting investors and lenders. That being said, a low AP turnover is only sometimes a signal that the company is struggling, as the company could be strategically hoarding cash.
When should I have a low AP turnover?
A low Accounts Payable Turnover Ratio can be acceptable if a company negotiates favorable payment terms with its suppliers. For example, a company may negotiate longer payment terms with its suppliers to improve its cash flow, allowing it to invest in other business areas. However, a consistently low APTR can indicate poor payment practices or strained supplier relationships.
How is AR turnover different than AP turnover?
While both ratios provide insight into a company’s working capital management, they reflect opposite sides of the equation. The AR Turnover indicates how frequently a company collects payments from its customers. A higher AR Turnover ratio suggests that a company has shorter collection periods, which means it receives cash for its sales faster and can reinvest that money into the business.
How do I improve the management of AP?
A fractional CFO can assess your AP process and offer improvement advice. Here is a list of typical AP best practices.
Implement fraud controls
Small business AP is the #1 source of fraud, both internal and external. Controls such as separation of duties and hacker education reduce the risk of fraud and embezzlement.
Streamline the billing process.
Implement a process to quickly and accurately enter bills, approve them, and schedule payments. Consider using automated expense management software to simplify this process.
Negotiate payment terms
Align supplier payment terms with your business and working capital needs. Negotiate longer payment terms to extend working capital and early payment discounts to boost net profit.
Prioritize payments to ensure that critical suppliers are paid on time and avoid late fees or penalties, while less critical suppliers are deferred if required by cash constraints.
Maintain good supplier relationships.
Communicate regularly with suppliers to build strong relationships and address any issues that may arise.
Outsource AP process
Outsourcing to an AP service organization will help businesses reduce costs, increase efficiency, and improve accuracy in payment processing, allowing them to focus on core business activities.
If you want to outsource your AP to a professional team, we would be happy to meet with you and discuss your options. Contact us now for your free consultation.