Analysts are often keen to examine the accounts payable relative to the purchase. It gives them an insight into the company’s relationship with its suppliers. Leeway to delay payments is a source of liquidity for the company.
Accounts payable definition
Accounts payable is the amount owed to the supplier when the company purchased goods or services on credit. In some financial statements, you might recognize it as a trade payable.
Credit purchases are usually for the following types of goods or services:
- Utility bills such as electricity and telephone
- Accrued employee salaries
- Office rent expense
The company records trade payables when it has received products or services from suppliers. The company will match the invoices from suppliers with the company’s records. When it is appropriate, companies record under current liabilities, as long as not paid. As a current liability, the company must pay following the provisions. Often, suppliers require short-term payment of (e.g., within 30 days after receipt). If it does not pay, the supplier can impose a fine.
That’s different from notes payable. Late payments can lead to the confiscation of company assets. The notes payable represent interest-bearing debt, and it requires timely payment to the lender.
Reporting accounts payable in the financial statements
The company records trade payables under current liabilities. For the accounting equation to remain balanced (assets are equal to liabilities plus shareholder equity), at the same time, the company also records purchases as an expense in the income statement. The expense reduces shareholder equity at the equal nominal value as the increase in liabilities.
For example, in mid-March, the company buys goods from a supplier for Rp100 and will pay in April. At the end of March, the company recorded trade payables in current liabilities of Rp100 (current liabilities increases) and operating expenses at the equal nominal (shareholders’ equity decreases).
At the end of April, the account cash and cash equivalents decreased by Rp100 for payment of the purchase of goods (assets decreases). At the same time, companies eliminate accounts payable (current liabilities decreases).
Why is it important, and how to analyze accounts payable?
The leeway to pay accounts payable is a source of liquidity for the company. I mean, companies don’t need to spend cash to pay immediately. It certainly gives the flexibility for companies to use some money.
But, if many accounts payable are due at the same time, it can dry up liquidity. The company must spend a large amount of money to pay for it.
Whether the accounts payable company is healthy or not, you can concern about its trend from time to time. Alternatively, you can also examine it from payable turnover and days payable outstanding. Both ratios tell you about the efficiency of management in managing the daily financial business.
Accounts payable turnover
This ratio measures how many times a company pays its suppliers in one year. The formula is as follows:
Accounts payable turnover = Purchase / Average accounts payable
Whereas, Purchase = Ending inventory + Cost of goods sold – Initial inventory
Usually, a low ratio is more desirable, if, at the same time, the company has enough cash. That is not an indication of liquidity problems and may be a result of lenient credit policies. In this case, the company has successfully exploited the leniency of credit terms.
Still, a low ratio indicates the company may also have difficulty in paying on time. That may be because of the company’s cash dried. So, you should check your the cash and cash equivalents account in the assets section.
Meanwhile, the ratio will be high when companies pay early to get discounts from suppliers. Or, it happens because the company cannot fully utilize the available credit facilities and pay suppliers too fast.
Days payable outstanding
Days payable outstanding (DPO) = 365/Payables turnover
Days payable outstanding measures how many days the company pays for the purchase of goods or services from suppliers. For example, a DPO of 30 indicates that, on average, a company needs 30 days to pay suppliers. The higher the DPO, the more time is available for companies to use their cash before paying suppliers.