What are accounts payable?
Accounts payable is the amount of cash a company is liable to pay to its suppliers and clear dues. As current liabilities of the company, accounts payable is required to be settled over the next twelve months.
It also shows the obligations of the business over the next year. Accounts payable is required to be repaid in a short period, depending on the relationship with suppliers. It is essentially a kind of short term debt, which is necessary to honour to prevent default.
As a part of the company’s working capital, it is widely used in analysing the cash flow of the business and cash flow trends over a period. Accounts payable may also depict the bargaining power of the company with its vendor and suppliers.
A vendor or supplier may give the customer longer credit period to settle the cash compared to other customers. The customer here is the company, which will incur accounts payable after buying goods on credit from the vendor.
There could be many reasons why the vendor is providing a more extended credit period to the firm such as long term relationship, bargaining power of the firm, strategic needs of the vendor, the scale of goods or services.
By maintaining a more extended repayment period to supplier and shorter cash realisation period from the customer, the company would be able to improve the working capital cycle and need funds to support the business-as-usual.
However, prudent working capital management calls for not overtly stretching the payable days as it might lead to dissatisfaction of supplier. Also, investors tend to closely watch the payable days cycle to determine the financial health of the business. When the financial conditions of a firm deteriorate, the management tend to delay the payment to their suppliers.
What is accounts payable turnover ratio?
Accounts payable turnover ratio shows the capability of a firm to pay cash to its customer after credit purchases. It is counted as an essential ratio to analyse the cash management attribute of the firm and its relationship with vendors or suppliers.
It is calculated by dividing purchases by average accounts payable.
Purchases by the company are calculated as the sum of the cost of sales and net inventory in a given period:
Now let’s understand this the help of an example. Let us suppose, Cost of sales of Company XYZ for the period was $60,000, and XYZ began with inventories worth $21000 and ended at $15000. Accounts payable at the beginning was $20000, and $15000 at the end.
Now the purchases will be $66000 (60000+21000-15000). The average accounts payable will be $17500. Therefore, the accounts payable turnover ratio will be 3.77x.
Dividing the number of weeks in a year by the accounts payable turnover ratio will give the number of weeks the company takes on average to settle its payables. In this case, it will be around 13.8 weeks (52/3.77).