How To Calculate Accounts Payable, Explained!

Accounts Payable represents a business’s unpaid expenses, and as AP increases, so does the cash balance. When you pay down the AP, the cash balance also gets reduced to the corresponding amount. Like other liabilities, AP affects your balance sheet by offsetting your assets to determine your total net worth. Calculating AP correctly yields accurate information about your business’ net worth and a complete picture of how your liabilities and assets are distributed.

A business’ AP will be measured in two key concepts: Total Accounts Payable Turnover (TAPT) or turnover ratio and Days Payable Outstanding (DPO).

Total AP turnover ratio (TAPT)  quantifies how efficiently your business pays the vendors – it shows the number of times the business pays off AP during a specific period. A higher AP ratio indicates that your company pays its bills in a shorter period. Low AP ratios suggest that your company is struggling to pay its bills or that you are using your cash strategically. Businesses that rely on lines of credit benefit from a higher AP ratio as their vendors and suppliers use that metric to gauge the risk they were to take.

Days Payable Outstanding (DPO) is a measure of the time taken by a business to pay off its suppliers or vendors. The average time (in days) that a business takes to pay off its creditors is measured by days payable. It is usually compared with the average payment cycle of the industry to gauge a company’s payment policy. The finance department uses this metric to measure how many days the establishment takes to settle its bills. DPO can provide you with critical guidance in balancing your AP & AR processes.

How to calculate Days Payable Outstanding?

A DPO of 25 means that, on average, it takes a business 25 days to pay back its vendors or suppliers.

To calculate the TAPT, you need to combine all purchases made from your suppliers during a particular accounting period, then divide that value by the average accounts payable during the same period

For example, if your company had a beginning AP balance of $550,000 at the start of the year and the ending AP balance was $601,000. The total purchases for the past year came out to $9,530,000.

Why is calculating the AP Turnover ratio important?

APTR is a short-term liquidity measure that quantifies the rate at which a business pays off its suppliers. It indicates how many times a company pays off its AP during a period. Ideally, a business has to generate enough revenue to clear its AP quickly but not so soon that it misses out on opportunities because it could have used that money to invest in other endeavours. By calculating APTR, the investors can gauge a company’s ability to meet its short-term obligations, and creditors can measure whether to extend a line of credit to the company.

Why is it essential to track a business’ Days Payable Outstanding?

DPO is a critical efficiency ratio that is used in cash cycle analysis. Measuring the average number of days a business takes to pay back its suppliers helps gauge if a company is making optimum use of its cash position.

The main objective behind calculating days payable outstanding is to check a company’s cash flow and improve its operational efficiency. It helps gauge whether a business’ payment policy is conservative or aggressive. It also helps measure the bargaining power of the buyer – the extent to which a company can exert pressure in negotiating favourable terms with vendors.

While a Low DPO indicates that a company makes early payments to its suppliers, a high DPO means a company is taking longer to do the same. Companies with Low DPO have less liquid cash to meet other business obligations. While those with high DPO have more liquid money that can be utilised to produce more goods or manage other operations, suppliers might refuse to do business or offer them discounts due to delayed payments. The trick, of course, is to find the right balance to optimise your cash flow.

Wrap up

Optimising Accounts Payable can help improve your business’ days payable outstanding ratio. A strategic approach can help you free up working capital to fuel your business’s growth and strengthen cost management while reducing AP processing complexity.

At QX, we have offered customised finance and accounting services to businesses across industries for almost two decades. Our outsourced Accounts Payable services can help you benefit from the latest procurement technology, achieve cost savings, and enhance supplier relationships.

Curious to find out how we can help standardise and automate your business’ AP functions? Reach out today to speak with our finance transformation experts.

Divya Ramaswamy

Originally published Apr 05, 2022 10:04:44, updated Apr 05 2022

Topics: Accounts Payable Automation, Accounts Payable Optimisation, Accounts Payable Process