3. Activity: Accounts Payable

PAYABLES TURNOVER

Payables turnover indicates how many times (per year) a firm replaces its accounts payables, on average. The ratio therefore measures the firm's ability to obtain credit from its suppliers and to pay them their bills. 

  • A high payables turnover ratio indicates that the firm does not rely heavily on trade credit from its suppliers. This could be the result of unvavorable credit terms or of suppliers with an aggressive collection department. 
  • A low payables turnover ratio, in contrast, implies that the firm receives more generous trade credit from its suppliers. This could be because the firm is in financial difficulties or because the suppliers' collection department is not very aggressive. 

 

The most common measure of payables turnover divides the firm's COGS during a specific period by the average value of accounts payable during that period:

 

Payables turnover = \( \frac{COGS}{\text{Average accounts payable}} \)

 

To illustrate, let's return to Hershey in 2015. From the firm's balance sheets and income statement we know (in millions of USD):

  • COGS in 2015: 4'004.0
  • Accounts payable beginning of 2015 (end of 2014): 482.0
  • Accounts receivable end of 2015: 474.3

The numbers imply that Hershey's average payables during 2015 were 478.2:

 

Average payables = \( \frac{\text{Accounts payable}_{2014} + \text{Accounts payable}_{2015} }{2} = \frac{482.0+474.3}{2} \)= 478.2.

 

Hence, the firm's payables turnover was 8.4:

 

Payables turnover = \( \frac{COGS}{\text{Average accounts payable}} = \frac{4'004}{478.2}\) = 8.4.

 

Put differently, the firm replaced its  accounts payable 8.4 times per year.

 

Again, a more intuitive way is to translate this turnover frequency into a turnover time. This will yield the so-called average payment period.

 

AVERAGE PAYMENT PERIOD

The average payment period (often also called Days Payables Outstanding, DPO) indicates the number of days the firm take, on average, to pay its bills. The longer the average payment period, the larger the amount of trade credit the firm receives from its suppliers. 

Formally, DPO is computed as follows:

 

DPO = \( \frac{\text{Average accounts payable}}{COGS} \times 365 \).

 

Alternatively, we find DPO by dividing 365 by the firm's payables turnover: 

 

DPO = \( \frac{365}{\text{Payables turnover}} \).

 

In the case of Hershey, we found a payables turnover of 8.4. Assuming a year has 365 days, this means that it takes Hershey, on average, 43.6 days to pay its bills:

 

DPO = \( \frac{365}{\text{Payables turnover}} = \frac{365}{8.4} \)= 43.6 days.

 
Compared with the days sales outstanding (DSO) of 29.6 from the previous section, this implies that Hershey receives more favorable credit terms than it grants its own customers.