How accounts payable relates to your financial KPIs.
There are many ways to measure the financial health of an organization, and the effectiveness of your finance department. We call these metrics key performance indicators, or KPIs. Let’s take a look at some of the more common financial KPIs, and where accounts payable (AP) fits in.
What is the AR/AP ratio?
AR/AP Ratio = AR / AP
The AR (accounts receivable) to AP ratio measures a company's liquidity, and ability to manage its short-term financial obligations. To calculate this ratio, divide your monthly AR by your monthly AP.
There’s no universally ‘good’ or ‘bad’ AR/AP ratio, as it varies depending on the industry, the company's specific circ*mstances, and its financial goals. But here’s a general rule of thumb:
AP > AR: You don’t want your accounts payable to exceed your accounts receivable, because that probably means you’re paying out more than you’re taking in.
AR > AP: You’ll want to see a ratio greater than 1:1, as that doesn’t give you much wiggle room. A ratio closer to 2:1 in favor of AR indicates a healthy business, but closer to 3:1 in favor might suggest you ought to look at growing your business, or investing that money in acquisitions or other areas.
However, it's important to consider your industry and specific business circ*mstances. Some industries, like retail, might expect to have a higher AR/AP ratio ― you’re probably selling a lot of products, and you’re unlikely to work with too many external vendors. Property management companies, for example, should expect a much smaller ratio.
What is the current ratio?
Current Ratio = Current Assets / (Liabilities + AP)
Th current ratio assesses a company’s ability to cover its liabilities (including accounts payable) with its current assets. Again, a 'good' ratio is dependent on various factors, including your industry, business model, and financial strategy ― but a ratio of between 1.5 and 2 is generally considered sufficient to cover your liabilities with enough room to spare.
You can calculate this ratio by dividing the total of your current assets by your liabilities, including your AP.
A ratio greater than 1.5 suggests your company relies less on its suppliers for short-term financing, which potentially indicates a stronger liquidity position and better financial management. It means your company has more of its current assets available to cover other short-term obligations.
By contrast, a current ratio of less than 1.5 can suggest your company is relying more on trade credit from suppliers to finance its operations. While this can be a strategic decision, it can also indicate that the company isn’t using its own resources effectively, and might have difficulty settling its accounts payable.
What is the AP turnover ratio?
AP Turnover Ratio = Net Credit Purchases / Average AP in the Same Period
The AP turnover ratio measures how many times your company can pay off its suppliers or creditors over a given accounting period. You can calculate this ratio by dividing your net credit purchases by your average AP for the same period ― giving you the number of times your accounts 'turned over'.
The AP turnover ratio is a performance metric. It’s less about aiming for a 'good' AP turnover ratio than tracking how your ratio changes from period to period. An increasing ratio means you’re paying off your suppliers more frequently/quickly than in previous periods ― a sign that you’re managing your cash flow effectively, and potentially taking advantage of early payment discounts. Conversely, a decreasing ratio means there are longer intervals between supplier payments, and could be a sign of cash flow issues.
Again, it’s not an exact science. Your ratio will be affected by your supplier relationships and payment agreements ― if you’ve arranged to pay a certain supplier every 30 days, that will be reflected in your turnover ratio but isn’t necessarily a sign there’s anything wrong.
What is the AP to COGS ratio?
The AP/COGs ratio is another way of calculating your AP turnover ratio. But instead of using your net credit purchases, you calculate it using your total cost of goods sold (COGS). As before, you take your total cost of goods sold and divide it by your AP for the same period to get your AP turnover ratio.
Net credit purchases are generally considered a truer metric for calculating your turnover ratio than COGS. Net credit purchases are equivalent to COGS plus ending inventory, minus beginning inventory ― giving a more accurate picture of your total payables,
What is the AP to sales ratio?
AP to Sales Ratio = AP / Sales
As the name suggests, the AP to sales ratio is a measure of a company’s accounts payable divided by its sales revenue for a particular accounting period. You’re looking for a low ratio here ― the closer you get to 1/1, the more likely it’s a sign your company has liquidity issues.
Here’s what constitutes a ‘good’ AP sales ratio in a nutshell:
Higher ratio: A higher AP to sales ratio suggests your company has a higher level of accounts payable relative to its total sales revenue. This may indicate the company relies more on trade credit and accounts payable as a source of financing.
Lower ratio: A lower AP to sales ratio means that your company has a smaller level of accounts payable relative to its total sales revenue, indicating that the company manages its payables more efficiently, or maintains a more conservative approach to short-term financing.
In summary
The above metrics are highly important in determining your company's financial performance, but more than that, they’re indicators of sound financial practice that can be used to deny or approve financing or credit applications. By optimizing your accounts payable workflows, you can achieve greater control over your cash flow. And subsequently, improve the financial performance of your entire organization.
