20 Understanding the Numbers
below their norm of about 25 times a year, or roughly every 2 weeks. As with
Accounts Receivable Turnover, an Inventory Turnover that is out of line is a
red f lag.
Accounts Payable Turnover
This measure’s equation is:
If Cost of Goods Sold is $100,000 and Accounts Payable is $16,600, then
which is about 6, or around 60 days. Again, note the consistency of the numer-
ator and denominator, both stated at the cost of the goods purchased. Accounts
Payable Turnover is evaluated by comparison with industry norms. An Ac-
counts Payable Turnover that is appreciably faster than the industry norm is
fine, if liquidity is satisfactory, because prompt payments to suppliers usually
earn cash discounts, which in turn lower the Cost of Goods Sold and thus
lead to higher income. However, such faster-than-normal Accounts Payable
Turnover does diminish liquidity and is therefore unwise when liquidity is
tight. Accounts Payable Turnover that is slower than the industry norm en-
hances liquidity and is therefore wise when liquidity is tight but inadvisable
when liquidity is fine, because it sacrifices cash discounts from suppliers and
thus reduces income.
This concludes our survey of the ratios relating to short-term liquidity—
the current ratio; quick, or acid test, ratio; Accounts Receivable Turnover; In-
ventory Turnover; and Accounts Payable Turnover.
If these ratios are seriously deficient, our diagnosis may be complete. The
subject business may be almost defunct, and even desperate measures may be
insufficient to revive it. If these ratios are favorable, then short-term liquidity
does not appear to be a threat and the financial doctor should proceed to the
next set of tests, which measure long-term solvency.
It is worth noting, however, that there are some rare exceptions to these
guidelines. For example, large gas and electric utilities typically have current
ratios less than 1 and quick ratios less than 0.5. This is due to utilities’ excep-
tional characteristics:
- They usually require deposits before providing service to customers, and
they can shut off service to customers who do not pay on time. Customers
are reluctant to go without necessities such as gas and electricity and
therefore tend to pay their utility bills ahead of most other bills. These
factors sharply reduce the risk of uncollectible accounts receivable for
gas and electric utility companies.
Accounts Payable Turnover=$,
$,100 000
16 600Accounts Payable Turnover Cost of Goods Sold
Accounts Payable=