In this series, we’re exploring metrics that impact your cash flow.
One thing that can make a big difference is purchases made on credit. That’s where your supplier bills you and you pay later, perhaps 30 or 60 or 90 days later.
The flip side of this, sales made on credit, where your customers pay you later, also makes quite a difference. We looked at that in detail in the last post.
Creditor Turnover Ratio only applies if you’re using accruals accounting. Here’s a quick primer on what accruals accounting is.
What are Creditors?
Your suppliers are either cash suppliers or credit suppliers. Credit suppliers are also called trade suppliers, accounts payable, or creditors.
The distinction has nothing to do with your method of payment, and everything to do with your speed of payment.
You pay cash suppliers immediately
If you nip into the supermarket for a ream of paper for the office, you pay them immediately, so this is a cash supplier. You could pay them with cold, hard, cash, or with a credit card; it doesn’t matter. They receive the payment immediately (or close enough).
If you book a workshop online for a team member, and you pay with a card then and there, then this is a cash supplier.
You pay credit suppliers (creditors) later. They’ve given you time to pay, which is what credit is.
Your supplier who brings you pallets of goods and invoices you later is a creditor.
The trainer you book to provide a day’s training for your whole team, who invoices you and awaits payment within 30 days, is a creditor.
Creditors are called Accounts Payables in some countries. You can remember it being accounts you need to pay money to. You’ll also see the Creditor Turnover Ratio called the Payables Turnover Ratio.
What is the Creditor Turnover Ratio and how do you find it?
The equation is:
Creditor turnover ratio = Net credit purchases Average creditors balance
What are Net Credit Purchases?
Usually, you get credit to buy your main supplies or the items you buy to resale. If this is entirely true for you, then use this formula:
Net credit purchases = Cost of Goods Sold Ending Stock Starting Stock
You should find your COGS toward the top of your profit & loss report.
Your stock figures will be on your balance sheet.
For example, if you buy 10 different brands of goods to resell, you may have credit with 7 of them, but not yet with the other 3 – perhaps they are new, or they simply don’t give anyone credit.
On top of that, you might have credit with your supplier of office goods, so you infrequently order cases of copy paper, envelopes, and stamps which are all overheads in your business. They are a creditor, but these orders won’t show up in your COGS.
If this is true for you, ask your bookkeeper to find your net credit purchases from the Accounts Payables report (or Creditors Report) in your accounting software.
What is your Average Creditors Balance?
Average creditors balance = (Creditors balance at the beginning of the year Creditors balance at the end of the year) 2
Your creditor balance is on your balance sheet. Look at the balance from the end of last year and the balance from the end of the year before. Average those two. That’s it, that’s all you need to do for this one!
Bonus: How do you find your Creditor Turnover in Days?
Creditor Turnover in Days = 365 Creditor Turnover Ratio
On average, your company pays its creditors in this many days.
Smaller numbers are better for this metric.
What is your Creditor Turnover Ratio?
Now go look at your own reports and find your Creditor Turnover Ratio. I’ll wait.
What does the Creditor Turnover Ratio tell us?
It tells us how many times per year your company pays its debts.
The higher this number, the faster you pay your credit suppliers.
This is a key metric in creditworthiness.
How can you use your Creditor Turnover Ratio?
If you need better cash flow, this is one metric to keep an eye on. You can work to decrease it whilst making sure you pay on time.
This can give you the breathing room, for example, to order stock and sell it before you need to pay for it.
This is exactly why trade credit is so common.
On the flip side, if you will be seeking credit soon – perhaps you’ll be applying for a large loan from a bank to fund an expansion – then you’ll want to work to increase this metric.
That will increase your creditworthiness, helping you have a better chance at getting that loan.
An aside on Prepayments and Accruals
Prepayments and accruals are the methods accountants and bookkeepers use to make sure that expenses and income are accounted for in the correct period.
For example, if your year end is 30 June, and your annual insurance invoice is dated 29 June, then really, essentially all of that expense should show up in the next financial year.
Entering prepayments and accruals on an annual basis is standard practice.
If you really want to keep an eye on your ratios, margins, etc, you’ll want your team to enter these more frequently. Ideally monthly, so that you can get a better handle on your month-by-month changes.
This applies across all your margins and ratios, really, not just this one.
What should you know when comparing Creditor Turnover Ratios?
Watch out for the timing of the underlying bookkeeping entries. That is, ensure your accountant or bookkeeper correctly handles prepayments and accruals to enable proper comparison.
For example, one of the figures going into the Creditor Turnover Ratio is COGS (Cost of Goods Sold).
It’s possible that you placed a big order for screws that go into the goods you’re manufacturing right before the month end. Let’s say you expect this batch to last you a year.
Or, as a service provider, perhaps a software you categorise as COGS had its annual renewal right before the end of the month.
Either way, if you want to keep a proper eye on this your Creditor Turnover Ratio every month or every quarter, ensure your finance team journals these expenses monthly as prepayments.
And, as with the Debtor Turnover Ratio, watch out for unintended consequences.
Trying to decrease this ratio means either
Decreasing your Net Credit Purchases or
Increasing your Average Creditor Balance
Start approving fewer credit purchases
That may be the right choice, but it may mean you’re not getting the supplies you need when you need them, and it’s strangling your business.
Pay your suppliers more slowly
That might be the right choice to get you through a bumpy period or a period of transition. (For example, if you actually have 60-day terms but have always paid the day you receive the invoice.) But it might also cause your suppliers to stop extending credit to you, again putting a choke hold on your business.
Trying to increase the ratio means you could see the opposite of everything above.
For example, perhaps your finance team approves far too many credit purchases, driving up your company debt far beyond what you’d like it to be.
So, as always, look at this together with other KPIs to help you keep on track for your desired outcome, avoiding the unintended consequences as much as possible.
Conclusion
In this post, we’ve learned about
-
- Your creditor turnover ratio
- Your creditor turnover in days
- Credit vs cash suppliers
- Net credit purchases
- Average creditors balance
- Prepayments and accruals
We’ve seen that:
-
- You can improve your cash flow by decreasing your Creditor Turnover Ratio.
- You can improve your creditworthiness by increasing your Creditor Turnover Ratio.
- Keeping an eye on several KPIs at the same time is important if you’re working to change your Creditor Turnover Ratio, to avoid unintended consequences.
Hi, I’m Sara-Jayne Slocombe of Amethyst Raccoon. I help your small business thrive using the power of your numbers, empowering you so that you have the confidence and knowledge to run your business profitably and achieve the goals you’re after.
I am a UK-based Business Insights Consultant, which means I look at your data and turn it into information and insights. I separate the noise from the signal and translate it all into actions that you can actually take in your business.
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