What are accounts payable (AP)?
– Accounts payable (AP) are short-term obligations a business owes to suppliers for goods or services bought on credit. AP is recorded as a current liability on the balance sheet because it is typically due within one year (commonly 30–90 days). AP functions like supplier-provided short-term credit: the company receives inputs now and pays later.
Why AP matters
– AP affects cash flow and working capital. Growing payables can mean a company is using supplier credit to conserve cash, or it could indicate cash strain if payments are being deferred because funds are tight. Timely payment preserves vendor relationships and favorable credit terms; poor management can trigger late fees, supply disruptions, and damaged credit.
Key definitions
– Current liability: an obligation due within one year.
– Trade payables: the portion of AP that comes specifically from buying inventory or inputs used in production/resale.
– Payables turnover ratio: measures how many times per year a company pays its suppliers.
Formula: Payables turnover = Net credit purchases / Average accounts payable
(If net credit purchases aren’t available, some analysts use Cost of Goods Sold (COGS) as an approximation.)
– Days Payable Outstanding (DPO): the average number of days it takes to pay suppliers.
Formula: DPO = (Average accounts payable / COGS) × 365
– Cash Conversion Cycle (CCC): the average days between spending cash on inventory and receiving cash from customers.
Formula: CCC = Days Inventory Outstanding (DIO) + Days Sales Outstanding (DSO) − DPO
How AP appears in the financial statements
– Balance sheet: AP is listed under current liabilities.
– Income statement: AP itself is not an expense. The underlying purchases may be recorded as expenses (or inventory that later becomes COGS), but AP only records the unpaid obligation.
– Cash flow: paying AP reduces operating cash flow when cash is actually disbursed.
Journal entries (double-entry bookkeeping)
– When a company receives goods or services on credit:
Debit (increase) Expense or Inventory; Credit (increase) Accounts Payable.
– When the company pays the invoice:
Debit (decrease) Accounts Payable; Credit (decrease) Cash.
– Example (office furniture purchased on credit for $10,000, due in 45 days):
Step 1 — at purchase:
Debit Office Furniture (asset) $10,000
Credit Accounts Payable $10,000
Step 2 — at payment (45 days later):
Debit Accounts Payable $10,000
Credit Cash $10,000
Worked numeric examples
1) Payables turnover
– Inputs: Net credit purchases = $130,000,000; Beginning AP = $25,000,000; Ending AP = $15,000,000.
– Average AP = (25,000,000 + 15,000,000) / 2 = $20,000,000.
– Payables turnover = 130,000,000 / 20,000,000 = 6.5 times per year.
Interpretation: on average the company pays its suppliers about 6.5 times a year.
2) DPO
– Inputs: Average AP = $15,000,000; COGS = $100,000,000; use 365 days.
– DPO = (15,000,000 / 100,000,000) × 365 = 0.15 × 365 ≈ 54.8 days.
Interpretation: it takes roughly 55 days on average to pay suppliers.
3) Cash Conversion Cycle (example)
– Suppose DIO = 45 days and DSO = 30 days, and DPO = 55 days.
– CCC = 45 + 30 − 55 = 20 days.
Interpretation: from paying for inputs to collecting cash from customers takes about 20 days on average.
Practical checklist to manage accounts payable effectively
– Centralize invoice receipt and maintain a single supplier inbox.
– Implement a three-way match (purchase order, goods receipt, invoice) before payment approval.
– Track AP aging (how long invoices remain unpaid) and reconcile monthly.
– Schedule payments to capture early-payment discounts when beneficial, but avoid paying too early if cash preservation is a priority.
– Use payment terms strategically (e.g., net 30, net 60) while maintaining supplier goodwill.
– Automate approvals and payment runs where possible to reduce errors and processing time.
– Segregate duties: different people should handle invoice approval, payment execution, and reconciliation to reduce fraud risk.
– Monitor AP metrics (turnover, DPO, aging buckets) and compare with industry norms.
When rising or falling AP matters
– Rising AP: could be efficient use of supplier credit, supporting short-term liquidity, or it could signal inability to pay.
– Falling AP: could mean accelerated payments (good relations, discounts) or that the company is replacing credit purchases with cash purchases.
Trade payables versus total AP
– Trade payables are the part of AP tied directly to operating purchases (inventory, production inputs). AP also can include non-trade items such as accrued expenses, utilities, and tax liabilities depending on accounting practice.
Assumptions and caveats
– Formulas above use a 365-day year; some analyses use 360 days—be consistent.
– Payables turnover should use net credit purchases if available; substituting COGS can distort the metric for businesses with significant non-credit purchases.
– Industry norms vary: acceptable DPO differs by sector, bargaining power, and supplier terms.
Sources
– Investopedia — Accounts Payable (definition and examples): https://www.investopedia.com/terms/a/accountspayable.asp
– Corporate Finance Institute — Accounts Payable (AP) guide and formulas: https://corporatefinanceinstitute.com/resources/accounting/accounts-payable-ap/
– U.S. Securities and Exchange Commission (Investor.gov) — How to read a financial report: https://www.investor.gov/introduction-investing/investing-basics/how-read-financial-report
– International Accounting Standards Board (IAS 1 — Presentation of Financial Statements): https://www.ifrs.org/issued-standards/list-of-standards/ias-1-presentation-of-financial-statements/
Educational disclaimer
This explainer is for educational purposes only and is not individualized financial, accounting, or investment advice. For guidance specific to your business or investments, consult a qualified accountant, financial advisor, or legal professional.