Accounts Payable

Accounts payable (AP), also known as trade payables, is a current liability on a company's balance sheet. It's a measure of how much money the company owes to vendors. Learn about the accounts payable definition, review examples, and see how to analyze AP.

What is Accounts Payable?


Accounts payable (AP) is a current liability account on a company’s balance sheet. The line item shows how much money the company owes to vendors, suppliers, and other creditors. When expenses are incurred, they can be paid in cash or paid on credit.
If they are paid on cash, no AP balance is recorded. If they are paid on credit, the AP balance increases. When the final payment is made, the AP decreases. You can think of AP as the total of all invoices and purchase orders that are made on credit and outstanding at this moment in time.
The accounts payable process, from receiving goods and creating an AP balance to making a payment and closing out AP.

In this post, we are going to discuss calculating accounts payable, the advantage of keeping an AP balance, the difference between AP and AR, and how to analyze a company’s accounts payable.


How to Calculate Accounts Payable


AP is short-term debt that you owe to suppliers, vendors, or other creditors. The payable shows that you have received the good or service and are still on the hook to pay them.

Accounts payable and accounts receivable are opposite accounts; if your company owes $10,000 to a supplier, you will have a $10,000 AP balance and the supplier would have a corresponding $10,000 AR balance.

If a company’s AP increases from one period to the next, that means they have purchased more goods or services on credit than they have paid down. On the other hand, if a company’s AP decreases from one period to the next, they have paid down more of their credit balance than they have added.

We are going to walk through how to calculate accounts payable now. Since accounts payable is a liability account on the balance sheet, a credit will increase the balance and a debit will decrease the balance. Remember to record the corresponding transaction as well. In this case, the corresponding transaction is to the cash account.

As a reminder, a debit increases an asset account and decreases a liability or equity account. A credit decreases an asset account and increases a liability or equity account.

For these purposes, a debit increases accounts receivable (a current asset) and a credit increases accounts payable (a current liability).

Here is an example transaction that walks through the AP process: Acme Inc. purchases $1,000 of office supplies. The invoice will be generated right away and shows that the credit terms are 14 days. The supplier will ship the goods right away and they will take 3 business days to arrive.


Acme Inc. Transactions


Purchase $1,000 of office supplies on credit

Dr $1,000 office supplies

Cr $1,000 accounts payable


Receive $1,000 of office supplies 3 days later

No journal entries needed


Pay the $1,000 invoice in full 14 days later

Dr $1,000 accounts payable

Cr $1,000 cash


Regardless of your industry, accounts payable management is a key part of managing cash flow. Your AP department needs to balance having too many unpaid invoices and having too little cash on hand.

 

Accounts Payable Examples


In short, an accounts payable balance is created any time you purchase a product or service but do not pay cash. This current liability account keeps track of all the money that you owe vendors, suppliers, and partners.

Examples of accounts payable items include:

  • Raw materials
  • Products and equipment
  • Office supplies
  • Legal bills
  • Invoices from contractors
  • Invoices from vendors

Now let’s explore an accounts payable example from the perspective of the company that owes the money.


Company A: Credit Transaction Example


Company A purchased $45,000 of raw materials that will be used to create their inventory. The supplier extended 30 day payment terms. Company A paid no cash on collection, and paid the invoice in full on day 30. Here are the journal entries.


Company A on Day 1

Dr 45,000 Raw Materials

Cr 45,000 Accounts Payable


Company A on Day 30

Dr 45,000 Cash

Cr 45,000 Accounts Payable


In this example, the company held a balance of $45,000 in their AP account until the invoice was paid in full. This is the purpose of the accounts payable account.

You can see how accounts payable gets more complicated in large companies with millions of dollars of credit being extended that needs to be managed. Large companies employ AP departments to create and manage the right workflow. Some teams even turn to accounts payable software and e-invoicing to help manage the sums.


Accounts Payable Metrics & Analysis


At a minimum, small businesses should review their AP balance once a week. This approach lets you frequently look at the numbers and build an institution of where your balance is throughout the year.

Larger organizations will have a dedicated payable team that manages the balances, when to make payments, tracking more detailed metrics, and more. This payable team should meet with the chief financial officer (CFO) or chief executive officer (CEO) at least once a week.

Here are a few metrics that will help your analyses.


AP Aging Schedule


A table that shows all unpaid supplier invoices by date range. This tool helps determine which invoices are overdue for payment. While the schedule will have small differences based on industry or company size, a typical aging report will follow this format:

  • Vendor Name
  • Total AP Balance
  • Due in 0-30 Days
  • Due in 31-60 Days
  • Due in 61-90 Days
  • Due in 90+ Days
Example of an accounts payable aging schedule with four sample vendors.

As you can see, aging schedules provide a quick glance at to which vendors need to paid back right away. This company should prioritize paying Umbrella Corporation or risk losing them as a vendor.



Days Payable Outstanding (DPO)


Days Payable Outstanding, DPO, is the average time expressed in days that a company takes to pay its creditors.


DPO Formula: (Average Accounts Payable / COGS) x 365 days


The average time expressed in days that a company takes to pay its creditors. This metric can cut through the noise and provide a single value to track to see if the company has been consistent with its repayments. It can be helpful to set alerts if DPO falls too low or goes too high.


Final Thoughts


Accounts payable, also known as trade payables, is a line item that is created when a company purchases goods and services on credit that need to be paid back in a short period of time. Great AP teams will provide visibility and transparency into the company’s cash and credit positions, which is vital for effective business management.
AP is a liability account, meaning it increases with a credit and decreases with a debit. The opposite account, accounts receivable (AR), shows how much money is owed to the company. How AP and AR convert to cash have serious implications for financial stability, growth, and overall cash management.

As mentioned, we recommend that companies build a well-documented payable process and look often at their AP balance, AP aging schedule, and days AP ratio. These metrics can often be the difference between running a stressful, cash-strapped business and a solid, profitable one.

Here are our suggestions:

  • Utilize accounting software or enterprise resource planning (ERP) software and electronic invoicing to minimize human error and cut down on the manual processes.
  • Negotiate more favorable terms with your suppliers, including early payment discounts. It might seem small but saving 1-2% on your invoices can add up to a significant delta on bills that you would have paid anyway.
  • Set weekly meetings with your team members to review your AP and AR, allowing for time to dig into the weeds, review your aging schedules, and gather new insights. Build this into a well-understood and documented AP process.
  • As your company scales to having hundreds of thousands or millions of dollars in AP, it makes sense to look into accounts payable automation software that can automatically enforce your business rules.

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