Payables turnover is an important activity ratio, and provides a measure of how effectively a business is managing its payables.
The payables turnover ratio measures the number of times the company pays off all its creditors in one year.
For example, a payables turnover ratio of 10 means that the payables have been paid 10 times in one year. A variant of payables turnover is number of days of payables. Number of days of payables of 30 means that on average the company takes 30 days to pay its creditors.
Purchases are taken from the Income Statement and Payables are taken from the Balance Sheet. Since the balance sheet tells the financial condition of a company at the end of the period, we take Average payables for the year in our calculation. For purchases we are generally concerned about the credit purchases. So, the analyst may have to exclude cash purchases from the total sales figure.
365 is the most commonly used day count convention however some analysts may prefer to use 360 days.
Assume that the credit purchases for a company for the previous year were $50,000 and the beginning and ending payables for the year were 8,000 and 12,000.
This means that the company paid all its creditors 10 times during the year.
This means that on average the company took 73 days to pay its creditors.
These ratios are an indicator of how fast or slow the company is pays its creditors.
The ratio is compared with others in the industry to measure the performance.
A low payables turnover ratio (or high days payables) is in favor of the company. However, it could also mean that the company is finding it difficult to make payments.
If a company has a high payables turnover ratio, it indicates that the company has very lenient payment policy, and it is probably not taking advantage of credit facilities. It can also mean that the company is using the discounts offered by the suppliers for early payments.