Creditors’ turnover ratio – how does it matter?
In the course of daily business operations, an organization has to make credit purchases and incur short-term liabilities. Suppliers of goods, i.e., creditors, are naturally interested in figuring out how long the firm is likely to take in repaying its trade creditors. So, for knowing this time period, creditors’ turnover ratio plays a crucial role.
What does it mean?
Creditors’ turnover ratio, being a good measure of short-term liquidity, is also referred to as payables’ turnover ratio.
Creditors’ turnover ratio reflects the speed at which the payments for credit purchases are made to creditors. This ratio is more or less computed on the same lines as the receivables’ turnover ratio is computed. It gives the average number of times that a business pays its creditors/suppliers over a reporting period (say a year).
The formula for calculating creditors’ turnover ratio
This ratio shows the relationship between net credit purchases and average accounts payables standing outstanding in a business’s books.
It is computed as follows:
Sometimes, the cost of goods sold (COGS) is also used in the numerator in place of net credit purchases.
Accounts payables include both creditors and bills payables. They are taken into account net of any returns made to suppliers.
Average accounts payables are calculated by taking the average of payables at the beginning and at the end of an accounting year.
Interpretation
Investors can use this ratio to determine whether a company has adequate revenue or enough cash balance to meet its short-term obligations. When compared to previous periods, a decreasing ratio may signify that a company is taking longer to pay off its suppliers than in previous periods. On the other hand, an increasing ratio may reflect that the company is paying off its vendors at a faster rate than in previous periods.
A low creditors’ turnover ratio indicates liberal credit terms granted by suppliers, while a high ratio shows that accounts of suppliers are settled rapidly.
Creditors usually measure this ratio before extending credit to a company since it is an indicator of creditworthiness and liquidity position. It can be best examined relative to similar companies operating in the same industry. For example, if nearly all of a company’s competitors have a ratio of at least four, the company’s ratio of two would be more troubling. Therefore, in that case, vendors may look for alternate trading partners in order to reduce the potential risk of not being paid.
A high ratio is typically considered more favorable. It may be due to the fact that vendors are demanding quick payments, or it could mean that the company is seeking to take advantage of early payment discounts or is actively working to boost its credit rating.
However, a high ratio could also indicate that the company is not reinvesting money back into its business (as it makes early payments), which could result in a lower growth rate and lower earnings for the company in the long term. Ideally, a company’s goal should be to generate enough revenue to pay off its accounts payable quickly, but not so quickly that it misses out on opportunities by not investing that money in other projects.
Conversely, a low ratio is indicative of slow payments to suppliers on account of the credit purchases being made. It could be due to favorable credit terms offered by vendors, or it may signal cash flow problems and hence, position a company in financial distress. But a low ratio may not necessarily indicate a worsening financial condition. It might be possible that the company has managed to negotiate better payment terms that allow it to make payments less frequently, without incurring any penalty. Thus, the creditors’ turnover ratio of a company is normally driven by the credit terms enjoyed by it. For instance, companies enjoying favorable credit terms usually report a lower ratio and vice versa.
Moreover, a business firm can also compare what credit period it receives from the suppliers and what it offers to the customers. This can be done by comparing payables’ turnover ratio with receivables’ turnover ratio.
Payables Velocity/ Average payment period
The creditors’ turnover ratio is used for figuring out the average payment period (or debt payment period). It can be computed as:
However, the average payment period can also be directly calculated as follows:
The creditors’ payment period gives insight about the promptness or otherwise in making payment for credit purchases. It shows the velocity of payments made by a firm towards its accounts payables. It denotes the average number of days that a payable remains unpaid.
A low debt payment period or high creditors’ turnover ratio signifies that the creditors are being paid promptly, hence enhancing the creditworthiness of the company.
However, an extremely favorable ratio to this effect also shows that the business firm might not be taking full advantage of the credit facilities that can be allowed by its creditors. This is why, sometimes, a longer credit period or velocity is considered better because it means that the company’s operations are financed interest-free by the suppliers.
Example
For example, if the credit purchases of XYZ Company during a year are $ 1,00,000, and average accounts payables amount to $ 25,000, then the creditors’ turnover ratio will be ‘4’ times (i.e., 1,00,000 / 25,000) while the creditors’ payment period would be 3 months (i.e., 12 months/4).
Thus, it signifies that, over the fiscal year, XYZ Company’s accounts payables turned over approximately 4 times during the year and it takes approximately 3 months (or 90 days) to pay its suppliers.
Key takeaway
Accounts payables’ turnover ratio quantifies the rate at which a company pays off dues to its suppliers and measures its efficiency in meeting short-term debts.
| A high creditors’ turnover ratio may be indicative of the following: | A low creditors’ turnover ratio may be indicative of the following: |
| Shorter payment period | Longer payment period |
| Early payments are made by the business | Creditors are not paid regularly and on time |
| The company may operate majorly on a cash basis. | A company could be in financial distress. |
| The company is not availing full credit period allowed to it. | The company has negotiated different payment arrangements with its suppliers, which allow it to make delayed payments. |
| The company has plenty of cash available to pay off its short-term debt obligations timely. | The company’s operations are financed interest-free by the suppliers. |
| The business’s creditworthiness is enhanced. |
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