Financial Ratios to Manage Accounts Payable

Managers need data to make informed decisions, and that data includes financial ratios. Financial ratios can be categorized as liquidity, solvency, and profitability ratios, and this discussion focuses on liquidity ratios. A ratio is a useful metric to assess results in the balance sheet, income statement, and other financial statements.

Businesses can use ratios to make decisions about a number of issues, including accounts payable. Accounts payable impacts cash flow, business operations, and your relationships with vendors. Stampli’s AP Automation gives you full control and visibility over all your corporate spending, and using Stampli also helps you manage accounts payable.

As an example for the discussion, assume that Premier Furniture is a business that manufactures and sells custom furniture pieces to the residential market. The period of time used to calculate ratios is typically one year, and different industries will generate different ratios.

Liquidity has a short-term focus, and managers should address liquidity needs first.

Working with Liquidity Ratios

The term liquidity refers to generating sufficient current assets to pay all current liabilities. Businesses that can’t produce enough current assets must borrow money or sell equity to pay current liabilities, and these choices have drawbacks. Borrowing money requires the debtor to pay interest, and selling equity means that the new shareholders have ownership rights in the business. As this podcast episode explains, decisions regarding liquidity impact a company’s ability to raise additional capital.

To use liquidity ratios, you need to review the accounts that make up current assets and current liabilities.

Understanding current assets and current liabilities

The term “current” refers to 12 months or less, and this term is used to determine if an asset or liability is current. 

Current assets include cash, and assets that will be converted into cash within 12 months, including accounts receivable and inventory. To understand current assets, think about transactions that require cash:

• Inventory represents items purchased (or produced) and held for sale. When you spend cash on inventory, you don’t recoup the cash spent until a sale occurs.
• The accounts receivable balance is the dollar amount of credit sales that have not been paid in cash.

The inventory and accounts receivable balances are expected to be converted into cash within a year. You can improve inventory management and account receivable collections to reduce these balances.

Current liabilities include accounts payable and other liabilities that must be paid within a year. If you’re paying $50,000 in principal and interest on a five-year loan within the next 12 months, this current portion of long-term debt is a current liability.

Here are some important liquidity ratios that many managers use to perform financial analysis.

Reviewing liquidity ratios

These are some of the most common liquidity ratios:

Current ratio

The current ratio is (current assets divided by current liabilities), and businesses want to maintain a current ratio of 1 or more. Premier Furniture has a current asset balance of $1,200,000 and a current liabilities total $980,000. The current ratio is ($1,200,000 divided by $980,000), or 1.2. 

The company has more than enough current assets to pay current liabilities. Some businesses adjust the current ratio formula by subtracting the inventory balance.

Quick (acid test) ratio

The quick ratio (or acid test ratio) subtracts inventory from current assets, and divides the result by current liabilities.

As discussed above, current assets are assets that will be converted into cash within a year. Many businesses believe that inventory takes the longest time to convert into cash, and the quick ratio is a more convervative view of liquidity.

If Premier Furniture’s inventory balance is $300,000, the quick ratio is:

($1,200,000 current asset balance less inventory $300,000) / $980,000 current liabilities = 0.9

When inventory is subtracted from the formula, Premier does not have enough current assets to pay all current liabilities. The business owner should analyze inventory sales and customer payments to determine if additional cash will be collected to cover current liabilities before the end of the year.

Using turnover ratios

Managers use turnover ratios to estimate how quickly sales are converted into cash received from customers. A business may sell inventory on credit, and then collect receivable balances from customers. When a business sells on credit and doesn’t collect cash immediately, the accounts receivable balance increases.

Accounts receivable turnover ratio

The accounts receivable turnover ratio measures credit sales and accounts receivable:

(net annual credit sales) / (average accounts receivable)

Credit sales are sales to customers who don’t pay immediately, and the net credit sales balance subtracts accounts receivable balances that are not collectable (bad debts). Finally, average accounts receivable is calculated as (beginning year balance + ending year balance) divided by two.

Let’s assume that Premier Furniture’s accounts receivable turnover ratios is:

($1,900,000 net annual credit sales) / ($280,000 average accounts receivable) = 6.8

Premier sells the dollar amount of average accounts receivable 6.8 times per year. In other words, the company’s inventory balance is sold and fully replaced 6.8 times. 

A higher ratio means that a business is collecting cash from sales faster, and does not need to carry as much inventory to generate sales. If average accounts receivable was $140,000 at the same level of annual sales, the turnover ratio would double to 13.6. As a result, Premier can operate with less cash tied up in inventory.

Inventory turnover ratio

The inventory turnover ratio is (cost of goods sold) divided by (average inventory), and average inventory is (beginning inventory + ending inventory) divided by two.

When inventory is sold, the balance is reclassified from the inventory asset account into the cost of goods sold account. The Premier turnover ratio is:

($1,680,000 cost of goods sold) divided by ($320,000 average inventory) = 5.3

Two points that managers need to remember:

• Cost of goods sold is the cost for both credit sales and sales paid for immediately in cash. The accounts receivable turnover ratio uses credit sales only.
• The quick ratio uses the inventory balance as of the end of a month or year, and the inventory turnover formula calculates average inventory.

Businesses want a high turnover ratio. Higher sales increases the cost of goods sold balance, and the goal is to generate higher cost of goods sold while carrying less inventory. Just as with accounts receivable, carrying inventory ties up cash, and lowering the average inventory balance frees up cash for other purposes.

A lower ratio occurs when sales (and cost of goods sold) decline, or when average inventory increases.

Accounts payable turnover ratio

This turnover ratio formula measures how many times a business pays its entire accounts payable balance during the year. Premier’s turnover ratio is ($2,000,000 purchases) / ($700,000 average accounts payable), which equals 2.9. Keep in mind that the purchase total is a different balance than the cost of goods sold. Not all purchases are related to inventory.

Working capital turnover ratio

Many companies measure liquidity based on working capital, which is current assets less current liabilities, and the goal is to maintain a positive working capital balance.

The working capital turnover ratio compares working capital to sales, and Premier’s working capital ratio is calculated as ($2,720,000 net annual sales) / ($240,000 average working capital) = 11.3. Management makes decisions to maximize sales in order to increase this ratio.

Turnover ratios also measure how efficiently a business uses assets to generate revenue. 

Other Turnover Ratios

Financially healthy businesses generate more revenue from the assets they own. For example, assume that a plumber has a $20,000 truck carrying $10,000 in equipment to perform plumbing work. The plumber’s goal is to maximize the revenue produced using the $30,000 investment. These efficiency ratio balances are also useful for managers:

Asset turnover ratio

This ratio is (total sales) / (average total assets). Premier’s goal is to use assets to maximize revenue, and the company’s asset turnover ratio is ($2,800,000 total sales) / ($2,900,000 average total assets), or 0.97.

Businesses can compare their financial ratios to industry benchmarks, and evaluate company performance. A low asset turnover ratio means that the company is not operating as efficiently as industry competitors.

Fixed asset turnover ratio

Fixed assets are assets that have a useful life of more than one year, and the plumber example above discusses fixed assets (truck and equipment). Premier’s formula is:

($2,720,000 net sales) / ($1,700,000 average fixed assets) = 1.6

Note that the asset turnover ratio above used $2,800,000 total sales. Net sales subtracts sales that are not expected to be paid by customers (bad debt), which is why net sales is lower.

Improving accounts payable management will have a positive impact on several financial ratios.

Managing Accounts Payable More Effectively

Stampli’s AP Automation helps you take control over bill and invoice processing, allowing you to process payables faster and with fewer errors. When you lower your accounts payable balance, you’ll see the results in several financial ratios:

• When you reduce accounts payable, current liabilities decline. A lower current liability balance improves the current ratio, quick ratio, and the working capital balance.
• Keeping accounts payable balances lower reduces the pressure to collect accounts receivable balances, in order to generate more cash to make B2B payments.
• Assume that you increase the inventory turnover ratio by reducing average inventory. Carrying less inventory decreases the accounts payable balance.
• Finally, reducing the average accounts payable balance means that vendors are paid sooner, and improves your relationship with vendors.

Stampli provides complete AP Automation software that brings together accounts payable communications, documentation, corporate credit cards, and check or ACH payments into one place. Stampli customers spend less time on accounts payable processing, and make fewer errors. Use Stampli to improve the financial ratios you use to manage the business.