The formula to calculate days in inventory is the number of days in the period divided by the inventory turnover ratio. This formula is used to determine how quickly a company is converting their inventory into sales. A slower turnaround on sales may be a warning sign that there are problems internally, such as brand image or the product, or externally, such as an industry downturn or the overall economy.The numerator of the days in inventory formula is shown at the top of this page as 365 to denote 365 days in a year. However, it is important to match the period in the numerator with the period for the inventory turnover used. For example, suppose that a company is calculating the days in inventory held based on a inventory turnover of 4.32 for one year. This can be divided into 365 days of the year for an average days in inventory of 84.49. If the same company has an inventory turnover of 2.31 for 180 days, the average days in inventory would be 77.92.How is the Days in Inventory Formula Derived?To understand the days in inventory held formula, one must look at the inventory turnover formula used in the denominator.

It is important to remember that the average inventory for the period is used. From here, the days in inventory formula can be rewritten as the numerator multiplied by the inverse of the denominator.

The 2nd portion of this formula is essentially the % of goods left to be sold, in terms of cost. This % of goods left to be sold can be used to estimate the % of time it is held prior to sale. The % of time products are held prior to sale can be converted into actual days by multiplying by 365 days in a year, or in a period.

Accounts payable turnover ratio (also known as creditors turnover ratio or creditors’ velocity) is computed by dividing the net credit purchases by average accounts payable. It measures the number of times, on average, the accounts payable are paid during a period.  Like receivables turnover ratio, it is expressed in times.

Formula:

In above formula, numerator includes only credit purchases. But if credit purchases are not known, the total net purchases should be used.Average accounts payable are computed by adding opening and closing balances of accounts payable (including notes payable) and dividing by two. If opening balance of accounts payable is not given, the closing balance (including notes payable) should be used.

Example:P&G trading company has good relations with suppliers and makes all the purchases on credit.  The following data has been extracted from the financial statements of P&G for the year 2012 and 2011:Purchases during 2012 $ 220,000

Purchases returns during 2012 20,000

Accounts payable on 31 December, 2011 40,000

Accounts payable on 31 December, 2012 20,000

Notes payable on 31 December, 2011 8,000

Notes payable on 31 December, 2012 12,000

Required: Compute accounts payable turnover ratio (creditors’ velocity).

Solution:

= $200,000* / $40,000**= 5 times

It means, on average, P&G company pays its creditors 5 times in a year.* 220,000 – 20,000** [(40,000 + 8,000) + (20,000 + 12,000)] / 2

Significance and Interpretation:Accounts payable turnover ratio indicates the creditworthiness of the company. A high ratio means prompt payment to suppliers for the goods purchased on credit and a low ratio may be a sign of delayed payment.Accounts payable turnover ratio also depends on the credit terms allowed by suppliers. Companies who enjoy longer credit periods allowed by creditors usually have low ratio as compared to others.A high ratio (prompt payment) is desirable but company should always avail the credit facility allowed by the suppliers.

Average payment period means the average period taken by the company in making payments to its creditors. It is computed by dividing the number of working days in a year by creditors turnover ratio. Some other formulas for its computation are give below:

Formula:This ratio may be computed in a number of ways:

Any of the above formulas may be used to compute average payment period. If credit purchases are unknown, the total purchases may be used.

Example:Metro trading company makes most of its purchases on credit. The extracted data for the year 2012 is given below:Total purchases $ 600,000

Cash purchases 150,000

Purchases returns 30,000

Accounts payable at the start of the year  65,000

Accounts payable at the end of the year 40,000

Notes payable at the start of the year 20,000

Notes payable at the end of the year  15,000

Required: Calculate average payment period from the above data.

Solution:When complete information about credit purchases and opening and closing balances of accounts payable is given, the proper method to compute average payment period is to compute accounts payable turnover ratio first and then divide the number of working days in a year by accounts payable turnover ratio.

= $420,000* / $70,000**= 6 times

Average payment period = 360 days /6 times60 days

The average payment period of Metro trading company is 60 days. It means, on average, the company takes 60 days to pay its creditors.*Computation of net credit purchases:Total gross purchases $ 600,000

Less purchases returns 30,000

———–

Net purchases 570,000

Less cash purchases 150,000

———–

Net credit purchases 420,000

———–

**Computation of average accounts payable:[(A/R opening +  N/R opening) + (A/R closing + N/R closing)] / 2[($65,000 + $20,000) + ($40,000 + $15,000)] / 2[$85,000 + $55,000] / 2$140,000 /2$70,000

Significance and interpretation:A shorter payment period indicates prompt payments to creditors. Like accounts payable turnover ratio, average payment period also indicates the creditworthiness of the company. But a very short payment period may be an indication that the company is not taking full advantage of the credit terms allowed by suppliers.

Managers try to make payments promptly to avail the discount offered by suppliers. Where the discount is available for early payment, the amount of discount should be compared with the benefit of the length of the credit period allowed by supplier