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Concept Behind Creditor's Turnover Ratio

The Creditors turnover ratio also knows as the accounts payable ratio is calculated by dividing the net credit purchases by the average trade creditors. It gives us the frequency with which payment is made to creditors in a business. It is similar to debtors turnover ratio where we analyse the speed with which amount is collected from debtors. It is a test of the company's liquidity position in the near term, typically one year. A company's creditors would encompass suppliers of raw materials in case of manufacturing companies or suppliers of spare parts, finished goods etc. It could also include service providers required in day to day operations of the business.

Let us take a numerical example. Consider the following figures for the year 2016.

Total purchases stand at USD 500,000 of which purchases worth USD 50,000 were made in cash. Good worth USD 25,000 were returned. Creditors at the end of the period were USD 60,000 and Bills Payable for the same period were USD 10,000.

Creditor Turnover Ratio = Annual Net Credit Purchase/Average Trade Creditors

Annual Net Credit Purchase will be calculated as Total Purchases Less cash purchases less good returned as we are dealing only with credit purchases. Average Trade creditors will include Creditors as well as bills payable.

Hence Annual Net Credit = 500000 - 50000 - 25000 = USD 425000

Average Trade Creditors would be = 60000 + 10000 = USD 70000

Credit Turnover Ratio = 425000/80000 = 5.31

This means the Company is paying its creditors 5 times a year on an average.Average trade creditors will be arrived at adding the opening as well as closing balances of creditors and dividing it by two. Further the average creditors does not account for any provisioning which is made for discounts on creditors if any.

This ratio is used in conjunction with the average payment period which indicated the number of days required by the company to pay its creditors.

Average Payment Period = Average accounts payable x No. of days in the year / Annual net credit purchases

or

No. of days in the year / Payable turnover ratio

Thus for the above case, Average Payment Period would be

365 / 5.31 = 68.7 days.

This implies that the Company pays its creditors every 69 days.

A high credit turnover ratio signifies that the company has good liquidity and pays its vendors promptly and help other creditors to take a call if they wish to associate with the Company. It could also be that the company is new to the creditor and may not be extending a higher credit period. It is an indicator of the credit worthiness of the Company.

It might also be possible that the company is making frequent payments without utilising the entire period of credit made available by the creditor. This could be due to cash discounts being enjoyed by the company. The number in itself would not mean anything until compared with the same ratio of companies with similar business within the industry.

This is also seen in conjunction with its debtor's turnover ratio as a company which collects money at a higher frequency than which it makes payments would be considered ideal. It would usually indicate a good liquidity position in the near term for the company.

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