What is Accounts Payable?
Accounts Payable (A/P) is defined as the total unpaid bills owed to suppliers and vendors for products/services already received but were paid for on credit as opposed to cash payment.
What is the Definition of Accounts Payable (A/P)?
Under accrual accounting, the accounts payable (A/P) line item on the balance sheet records the cumulative payments due to 3rd parties such as suppliers and vendors.
Accounts payable, often abbreviated as “payables” for short, represents invoiced bills to the company that has not been paid off – for that reason, accounts payable is categorized as a liability on the balance sheet since it represents a future outflow of cash.
Expenses must be recorded once incurred per accrual accounting standards, which means when the invoice was received, rather than when the company pays the supplier/vendor.
Therefore, the accounts payable balance increases when a supplier or vendor extends credit – i.e. a company places an order for products or services, the expense is “accrued”, but the cash payment is not yet paid.
Is Accounts Payable a Current Liability?
The relationship between accounts payable and the free cash flow (FCF) of a company is as follows:
- Increase in Payables (A/P) → Company has been delaying payments to its suppliers or vendors, and the cash remains in the company’s possession to date.
- Decrease in Payables (A/P) → Eventually, the suppliers/vendors are going to be paid with cash and when that occurs, the accounts payable balance declines in effect.
With that said, if a company’s accounts payable is consistently on the higher end relative to that of comparable companies, that is typically perceived as a positive sign.
By pushing back and delaying the required payments, despite already receiving the benefits as part of the transaction, the cash belongs to the company for the time being with no restrictions on how it can be used.
Therefore, an increase in A/P is reflected as an “inflow” of cash on the cash flow statement, whereas a decrease in A/P is shown as an “outflow” of cash.
What is the Difference Between Accounts Payable and Accounts Receivable?
On the balance sheet, the accounts payable (A/P) and accounts receivable (A/R) line item are conceptually similar, but the distinction lies in the perspective. Hence, while payables are recognized as a current liability, receivables are a current asset.
- Accounts Payable (A/P) → To reiterate from earlier, payables are the unmet payment obligations owed to third-parties such as suppliers and vendors for goods or services already received.
- Accounts Receivable (A/R) → In contrast, receivables are the payments that customers owe to a company for products or services already delivered to them, i.e. an “IOU” from customers who paid in the form of credit, rather than cash.
How to Forecast Accounts Payable?
For purposes of forecasting accounts payable, A/P is tied to COGS in most financial models, especially if the company sells physical goods – i.e. inventory payments for raw materials directly involved in production.
An important metric related to accounts payable is days payable outstanding (DPO), which measures the number of days on average it takes for a company to complete a cash payment post-delivery of the product/service from the vendor.
If DPO gradually increases, this implies the company might have more buyer power – examples of companies with significant buyer power include Amazon and Walmart.
How to Increase Accounts Payable?
From the perspective of suppliers/vendors, landing contracts with large purchase volumes and global branding cause them to lose negotiating leverage; hence, the ability of certain companies to extend payables.
Other factors that can enable a company to extend its days payable outstanding (DPO) are the following:
- Large Order Volume on a Frequency-Basis
- Large Order Size on a Dollar-Basis
- Long-Term Relationship with Customer (i.e. Consistent Track Record)
- Smaller Market – Fewer Number of Potential Customers
Accounts Payable Formula (A/P)
In order to project a company’s A/P balance, we need to compute its days payable outstanding (DPO) using the following equation.
Historical trends are used as a reference, or an average can be taken with the industry average used as a reference.
Using the company’s DPO assumption, the formula for the projected accounts payable is as follows.
Accounts Payable Calculator
We’ll now move to a modeling exercise, which you can access by filling out the form below.
1. Balance Sheet Assumptions
In our illustrative example, we’ll assume we have a company that’s incurred $200 million in cost of goods sold (COGS) in Year 0.
- Cost of Goods Sold (COGS) = $200 million
At the beginning of the period, the accounts payable balance was $50 million, but the change in A/P was an increase of $10 million, so the ending balance is $60 million in Year 0.
- Accounts Payable, BoP = $50 million
- Change in A/P = +$10 million
- Accounts Payable, EoP = $60 million
For Year 0, we’ll calculate our company’s days payable outstanding (DPO) using the following formula:
- DPO – Year 0 = $60m ÷ $200m x 365 = 110 Days
2. Accounts Payable Calculation Example
As for the projection period, from Year 1 to Year 5, the following assumptions will be used:
- COGS – Increase by $25m/Year
- DPO – Increase by $5m/Year
Now, we’ll extend the assumptions across our forecast period until we reach a COGS balance of $325 million in Year 5 and a DPO balance of $135 million in Year 5.
For example, to calculate the accounts payable for Year 1, the formula shown below is used:
- Year 1 A/P = 115 ÷ 365 x $225m = $71m
Starting from Year 0, the accounts payable balance doubles from $60 million to $120 million in Year 5, as captured in our roll-forward in which the change in A/P subtracts the ending balance in the current year from the prior year’s balance.
The cause of the increase in accounts payable (and cash flows) is the increase in days payable outstanding, which increases from 110 days to 135 days under the same time span.
The ending balance in the accounts payable (A/P) roll-forward schedule represents the outstanding payments owed to suppliers/vendors and the amount that flows to the accounts payable balance on the company’s current period balance sheet.
