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.
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.
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.
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.
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.
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.
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:
Now let’s explore an accounts payable example from the perspective of the company that owes the money.
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.
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.
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:
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, 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.
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:
Track metrics like the top performing ecommerce stores.