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Just like accounts receivable turnover ratio show the financing that the firm is providing to its buyers interest free, the accounts payable turnover ratio show the financing that the firm is able to receive from its vendors and suppliers free of cost. Since there are no interest charges involved and this is purely trade credit, the objective of the firm ideally should be to pay its bills as late as possible. By doing so, they are using the vendors money to temporarily finance their own business without any cost attached. However, due care must be taken that vendors are not passing off the finance charges in the form of higher prices for products purchased. In that case, the firm may be better off using its own money to buy products at a lower price from vendors that charge a lower price.
Accounts Payable Turnover Ratio = Net Credit Purchase / Average Accounts Payables*
Average Accounts Payables = (Beginning Accounts Payables + Ending Accounts Payables) / 2
This formula converted to a percentage shows the average amount of payables that are outstanding. The calculation of this ratio is just like the calculation of accounts receivable turnover ratio. Hence we can use the same example to understand the calculation of this ratio as well. However in this case we shall consider the accounts payables to be 40% of all credit purchases
The calculation of number of days outstanding ratio therefore is as follows:
Number of Days Receivables Outstanding = (40 / 100) * 360
*For the purpose of calculation of ratios accountants assume that the year has 360 days.
The answer to the above is 144 days. The firm therefore pays its bills every 144 days on an average. This means that the old bills are replaced a new set of bills every 144 days. Therefore in 360 days, the receivables are turned over (360 / 144) 2.5 times.
The accounts payable turnover ratio can be considered to be the exact inverse of the accounts receivable turnover ratio. In that case the objective was to receive payments as soon as possible. Here the objective is to delay payments as much as possible and utilize this free source of funds to finance the firm’s own business short term. Bargaining power once again has a big role to play in the accounts payable ratio. A lower accounts payable ratio entails that the firm has the bargaining power which allows it to pay its vendor late. However, COGS of the company must also be checked to ensure that more payment period is not being passed off as high price to the firm.
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