The Metric That Is Costing You Money and How to Fix It
Maintaining a good accounts payable turnover ratio is a delicate balance of efficiency, cash management, and vendor terms. Also called the Accounts Payable Days Formula or simply “Creditor Days”, this is a formula to calculate a “turn”-the number of AP cycles in a fiscal year- and the average number of days an invoice remains open. The ratio ultimately shows how frequently a company pays vendors in a given accounting period and is one of several measures of short-term liquidity. But there’s a reason payables are considered a liability—they mean the difference for you on credit ratings and vendor approvals and will definitely play a role in the terms you’re given. How can you focus on improving this measure?
Calculate and Compare
To use this baseline effectively, it’s important to understand what your ideal AP cycle is. More and more suppliers are offering longer payment terms to their key customers. To create a reliable metric, you have to examine the terms and the spend you have with each vendor in order to weight their influence appropriately. Compare your turns to other businesses in your industry for a benchmark. Knowing this ratio before it gets upside down is the best way to stave off potential problems. Remember that the goal isn’t always to move your ratio to one end of the extreme or the other. You need to make sure it stays consistent and it reflects good cash management.
Process Invoices Quickly—Pay When Ready
Delayed invoice processing can have significant ramifications. If your AP department is paying invoices on the fly, or when they’re already late, you can accumulate additional fees or expedited payment charges. Having multiple invoices open with a single vendor past terms won’t just hurt your credit-misapplied payments can create reconciliation nightmares that take hours of expertise to unravel. The invoice date should always determine the start date for payment terms and your payment proposals should exclude anything that will be due before your next scheduled run. Having an invoice in the ERP system doesn’t mean it’s going to get paid right away. It just gives you the clearest possible understanding of future cash flow.
Find Opportunities to Work with Your Vendors
Maximizing your terms can be a huge advantage in terms of cash management. However, don’t overlook the opportunity to save real cash over the long term. Many vendors offer small discounts, usually 2%, to customers who pay within an earlier timeframe. This can have major benefits, especially for high volume vendors. Consider this—if you spend $500,000 annually with a vendor and pay most of your invoices within the discount timeframe, you’ll earn almost $1,000 in additional funds for the business. Having the cash on hand can be beneficial but if you need to cut costs quickly without huge disruptions, be sure to evaluate your chances to earn more with existing vendors. Conversely, if you have to find ways to keep more cash on hand quickly, you can look to your vendors to extend their terms. A company that has good standing with their suppliers is much more likely to be given leniency than one who doesn’t.
Your business is unique. Some of the problems you face may not be. The accounts payable turnover ratio is just one way of calculating AP efficiency. Difficulty managing intake, inconsistent processes, and lengthy exception lists are some of the practices a lot of companies get into, not realizing the long-term problems. Fortunately, business process specialists can work with you to review these processes and help you get the most out of this ratio.