A calculation of the days of accounts payable gives an outside observer a fair indication of a company’s ability to pay its bills on time. If the accounts payable days are inordinately long, this is probably a sign that the company does not have sufficient cash flow to pay its bills and may find itself out of business in short order. Alternatively, a small number of accounts payable days indicate that a company is either taking advantage of early payment discounts or is simply paying its bills earlier than it has to.
Divide total annualized purchases by 365 days, and then divide the result into the ending accounts payable balance. An alternative approach is to use the average accounts payable for the reporting period, since the ending figure may be disproportionately high or low. The amount of purchases should be derived from all non-payroll expenses incurred during the year (payroll is not included because it is not a part of the accounts payable listed in the numerator). Also, depreciation and amortization should be excluded from the purchases figure since they do not involve cash payments.
The formula is:
Purchases / 365
Accounts Payable Days Calculation Example
The Lie Dharma Putra Company has beginning accounts payable of $145,000 and ending accounts payable of $157,000. On an annualized basis, its total expenses are $2,400,000, of which $600,000 is payroll and $50,000 is depreciation. To determine its accounts payable days, we plug this information into this formula:
($145,000 Beginning payables + $157,000 Ending payables) / 2
($2,400,000 Total expenses – $600,000 Payroll – $50,000 Depreciation) / 360
$151,000 Average accounts payable
———————————————— = 31 Days
$1,750,000 Purchases / 360
Cautions!: The most difficult part of this formulation is determining the amount of annualized purchases. If a company has an irregular flow of business over the course of a year, then estimating the amount of purchases can be quite difficult. In such cases, annualizing the amount of purchases for only the past month or two will yield the most accurate comparison to the current level of accounts payable because these purchases are directly reflected within the accounts payable in the numerator. The measurement can yield inaccurate results if a company is making large additional purchases that are being capitalized into inventory or fixed assets. These purchases represent a drain on cash, yet they are not included in the formula and so can lead one to assume that a company has more liquidity than is really the case. This situation can be reversed if a company is drawing down its inventory stockpiles to make sales rather than purchasing new inventory to meet the sales requirements, which will yield greater liquidity than is indicated by the measurement.