Editor’s Note: This is one of an eight-part series about key financial terms all entrepreneurs should know.
If you’ve never taken an accounting course, “Payables Turnover Ratio” might sound like a complex, intimidating term. Thankfully, that’s not the case. By the end of this article, you’ll understand what it means, why it matters, and how it can impact your ability to raise capital. Who knows … you may even find yourself calculating your business’s most recent payables turnover ratio just for fun.
What is a payables turnover ratio?
In simple terms, payables turnover ratio means how quickly a business is able to pay back its suppliers. The ratio is calculated by dividing cost of sales and dividing it by the average accounts payable amount during the period you’re measuring. Businesses looking to raise capital should be prepared to show payables turnover ratio on an annual basis for the past three years (assuming the company is three years old), and on a quarterly basis for at least the previous eight quarters. Some potential investors may also request monthly reports. The payables amount can be found on a company’s balance sheet under “current liabilities.”
Why does a payables turnover ratio matter?
In general, healthy companies are able to pay back their debts quickly because they’re generating income and operating in the black. The payables turnover ratio gives potential investors a quick look at how frequently a company is paying down its debt obligations. If a turnover ratio is increasing over time, a company may be paying off its debts faster. A decreasing ratio may mean pay back is taking longer, which could be a sign that a company’s financial condition is declining.
A decreasing ratio isn’t always a bad thing. For instance, if your company has one major supplier who provides many of your raw materials and you negotiate longer payment terms (moving from Net 30 to Net 60, for instance), your payables turnover ratio will decrease. Be prepared to explain any such change to a would-be investor, along with its benefits or challenges.
How can payables turnover ratio impact your financing options?
Alissa Bryden, author of 100 Entrepreneurs and a CPA at Virtual Heights Accounting says liquidity ratio is important as entrepreneurs seek funding for their businesses. “The payable turnover ratio is used by creditors and lenders to consider a company’s ability to pay off its current debts (specifically its trade or accounts payables),” Bryden explains.
“If a company can easily pay off its current accounts payable and continues to do so, then it indicates that the company will not burn through additional capital catching up on old debts.” That’s important, she says, because it “offers an indication that the additional capital can be used for future growth,” which is the kind of investment firms look for.
How can I improve my payables turnover ratio before seeking funding?
“To increase this ratio, a start-up can ensure it is paying down its debts prior to month or period end,” Bryden says. “This is because the average payables are based on an opening and closing month end calculation. Funders want to see you are putting their funds to good use.”
What does it mean to put funds to good use? Although the exact interpretation will vary by industry and company, Bryden says an across-the-board measure is minimizing costs that are not related to growth. “Reducing administrative costs and streamlining processes can assist you in increasing this ratio without affecting your future growth — or the lender’s future return,” she says.
Does the payables turnover ratio go by any other name?
Yes! You’ll sometimes see payables turnover ratio referred to as “accounts payable turnover” or “the creditors’ turnover ratio.” Each term means the same thing and can be used interchangeably.
Just like it’s easier to travel in a foreign country when you know the language, it’s easier to raise capital (or secure any kind of funding for your business) when you’re familiar with key financial terms and their real-life applications. Don’t forget to check out our previous installments on turnover ratio, debt to income ratio and current ratio.