Days’ Purchases in Accounts Payable

Measuring the Ability to Pay 

Any judgment regarding payment of current liabilities should be made in the light of the degree of urgency of payment. There are several measurements that can be made to assess the company’s policy in paying off current liabilities. Such analysis could be used by new suppliers to assess the timeliness and credit-worthiness of the company. 

Measurement of days’ purchases in accounts payable usually indicates the payment. terms that the company has with its suppliers, assuming that the company is not in default on their payments.

Days’ Purchases Payable = Average Accounts Payable x 365
                                             Credit Purchases

Determining credit purchases may be impossible for an outside analyst. A reasonable approximation is to substitute total purchases instead of credit purchases. Total purchases can be determined by adjusting the cost of goods sold by the changes in inventory balance. A large ratio would indicate that either the company has good relationship with its suppliers and enjoys liberal payment plan, or is delinquent in making payments. Further investigation of the credit terms with its major suppliers would provide a reasonable assessment of which of these is true for a particular situation. A larger number than the firm’s credit terms would indicate past due obligations. 

The formula also uses average accounts payable, which is the current year plus the prior year ending accounts payable divided by 2 (assuming even purchasing patterns throughout the year). However, sometimes this formula is calculated simply using ending accounts payable.