Trade credit is an essential source of finance for small businesses. It is especially important when firms find it challenging to obtain funding via financial or credit institutions. Since the financial crisis, trade credit in the form of accounts payable and accounts receivable has become a stable source of funding.

It is an important cash management tool and its use is indeed two-fold. You as a business can be viewed as a supplier, and your accounts receivables represent the amount of money you lend to your customers. Likewise, you are also a customer of your vendors and your accounts payable represent your borrowings from such suppliers.

Therefore, a combination of accounts payable and accounts receivable is important for your business’s performance. In this article, we will talk about the what accounts payable means, the accounts payable journal entry, the accounts payable process, and examples of accounts payable.

In this article, you will learn:

What Is Accounts Payable?

Accounts payable refers to the money your business owes to its vendors for providing goods or services to you on credit. Typically, these are the short-term debts that you owe to your suppliers.

In other words, the total amount outstanding that you owe to your suppliers or vendors comes under accounts payable. This will be represented under current liabilities on your firm’s balance sheets, because accounts payable become due for payment within a year.

In addition to this, your cash flow statement represents an increase or decrease in accounts payable from prior periods. For example, if your firm’s accounts payable increases as compared to the previous period, this means that your business is purchasing more goods on credit than cash. However, if your accounts payable reduce relative to the previous period, this implies that you are meeting your short-term obligations at a faster rate.

As a result, accounts payable management is critical for your business to manage its cash flows effectively.

What Is the Role of Accounts Payable?

Accounts payable management is essential when running a small business, because it ensures that your accounts payable contributes positively towards your business’s cash flows. This means it helps you to minimize late payment costs, such as interest charges, penalties, etc.

It also helps to reinvest the funds into your business that you would have otherwise paid to your suppliers, as accounts payable acts as an interest-free source of finance for your business, provided these are managed effectively.

In addition to this, effective accounts payable management practices ensure that you're building trust with your suppliers by honoring the agreed payment terms and paying your suppliers on time. Building trustworthy and strong relationships with suppliers are essential, because it'll help you to receive goods on better credit terms from your vendors.

Effective accounts payable management also ensures that proper controls are in place and helps to avoiding errors, such as duplicate payment, inaccurate invoices, fraud by suppliers, inefficient processes, or late payment.

Accounts payable, if managed effectively, indicates the operational effectiveness of your business. Too high of an accounts payable indicates that your business will face challenges in settling supplier invoices, however, too low accounts payable indicates your business is giving up on the benefits of trade credit.

Proper accounts payable management helps when organizing and maintaining supplier information and payment terms. This means it ensures that all the vendor invoices, purchase orders, and other expenditures are tracked and paid on time, it will also help in avoiding missing payments.

What Is the Accounts Payable Process?

Streamlining the accounts payable process is an essential part of growing and developing your business, though, as managing accounts payable is a backend task, it is often overlooked. You need to make your accounts payable process efficient so that it provides a competitive advantage to your business.

The main goal of implementing the accounts payable process is to ensure your bills are paid and that invoices are error-free and legitimate. The accounts payable department of each business will likely have its own set of procedures in place before making payments to vendors.

However, before streamlining your accounts payable process, it is essential to understand what the accounts payable cycle is. The accounts payable cycle is a part of your purchasing cycle, and includes activities essential to completing a purchase with your vendor.

Considering a complete accounts payable cycle, your accounts payable process must include the following steps:

Capturing Data Through Chart of Accounts

An ideal accounts payable process begins with a proper chart of accounts, which is statement or report that captures all your accounting transactions, including accounts payable. QuickBooks Online Accounting Software categorizes your transactions and breaks them down into categories, such as assets, liabilities, income, and expenses.

Generally, QuickBooks provides a list of standard accounts, like accounts payable, accounts receivable, purchase orders, payroll expenses, etc. However, if you do not see one that you need, you can add your own manually in your chart of accounts.

The chart of accounts helps you track your accounts payable expenses in a proper manner, and you can also generate your chart of accounts in Microsoft Excel or Google Sheets.

Add Vendor Details

When you're starting your business, you'll need to add the details of all your suppliers into your accounting software or Microsoft Excel Sheet.

If you're using online accounting software, like QuickBooks, you can add your suppliers details into the software itself, these details will include address, email, contact number, website, tax registration number, etc.

You can also include the payment terms agreed upon by the suppliers, which will specify the time period that you will take to make payment to your suppliers.

The standard payment terms include net 10, net 20, or net 30. For example, if your supplier sends an invoice with payment terms of net 30, the invoice date will be October 10 and you are required to pay by November 9, at the latest, otherwise, it would be considered a late payment.

The other set of standard payment terms can include 2/10 net 30. If we consider the same example as above, the 2/10 net 30 payment term means you can take a 2% discount on the total due amount if you pay your invoice by October 9, otherwise you'll have to pay the full amount due by November 9.

Checking and Filling Invoice Details

Examining invoices is essential to ensure the accuracy of data, so you'll need to check the invoices received from your suppliers thoroughly. You'll need to cross-check the goods received from your suppliers with those mentioned in the invoice and check whether you have received all the services that were mentioned in the vendor invoice. Once you have reviewed all the received invoices, you can start filling in the invoice details.

If your vendors create and send invoices using an invoicing software, then the invoice details will get uploaded to your accounting software automatically. However, if your vendors create and send invoices manually, then you'll need to manually fill in the details in your accounting software or books of accounts.

Process Payment

You need to keep a track of your accounts payable to know when the payments are due, so you can make the payments to your suppliers on time.

QuickBooks Online Accounting Software allows you to keep a track of your accounts payable that are due for payment. This can be done by generating reports like the 'Accounts Payable Aging Summary' report or the 'Accounts Payable Aging Detail' report.

For example, the 'Accounts Payable Aging Summary' report, not only tells you about the vendors that you owe money to, but it also highlights the invoices against which payments are overdue.

If you are using manual accounting software, then you will have to review the due date of each of the invoices, so you know which invoices are due for payment. Once you've reviewed all the invoices, the next step is to process those payments.

There are a number of ways in which you can make payments against the invoices, such as:

• Write a check
• Pay electronically
• Process checks via accounting software
• Pay through company credit card

Repeat the Process

You must process your invoices on a regular basis, regadless of the number of vendors you have, so you can follow the above procedure either weekly or fortnightly. This can help to reduce your workload at the months-end, and following a weekly or a fortnightly accounts payable cycle can help you avoid late payments.

What Is Included in Accounts Payable?

Accounts payable refers to the vendor invoices against which you receive goods or services before payment is made, meaning you've purchased goods on credit. In this instance, as they are supplying goods on credit, your suppliers are also referred to as trade creditors.

Since you've purchased goods on credit, the accounts payable is recorded as a current liability on your company’s balance sheet.

It is important to note that the accounts payable category represents the short-term obligations of your business. Meaning it represents the aggregate amount of short-term obligations that you have towards suppliers of goods or services.

The accounts payable account also includes the trades payable from your business, because this refers to the amount of money that you owe your suppliers for products related to inventory.

Inventory includes the raw materials needed to produce goods for sale or finished goods. That is, trades payable is the amount for which you bill your suppliers for those goods or services that you use for the ordinary course of business.

Therefore, if your business has only a few accounts payable, you may record them directly in your general ledger. However, if you have a large number of accounts payable, you'll first record the individual accounts payable in a sub-ledger.

A sub-ledger consists of the details of all individual transactions of a specific account like accounts payable, accounts receivable, or fixed assets. The total of all these individual transactions can then be recorded in the general ledger.

What is Accounts Payable Turnover?

Accounts payable turnover refers to the ratio which measures the speed at which your business makes payments to its creditors and suppliers, indicating the short-term liquidity of your business. It reflects the number of times your business has made payments to its suppliers in a specific period of time, signifying your businesses efficiency in meeting short-term obligations and making payments to suppliers.

Accounts Payable Turnover Ratio Formula

In order to figure out the accounts payable turnover ratio, you'll first need to calculate the total purchases made from your suppliers. These purchases are made during the period for which you need to measure the accounts payable turnover ratio.

Then, you'll need to calculate the average amount of accounts payable during such a period. Finally, you can calculate the accounts payable turnover ratio using the following formula:

Accounts Payable Turnover Ratio Formula = Total Purchases from Suppliers/((opening accounts payable + closing accounts payable)/2)

Or

Accounts Payable Turnover Ratio = Total Purchases from Suppliers/Average Accounts Payable

You will need to deduct all the cash payments made to the suppliers from the total purchases from suppliers in the above formula. This is because the total supplier purchases should include only credit purchases

Analysis of Accounts Payable Turnover Ratio Formula

Your company is paying slowly to its suppliers if its accounts payable turnover ratio falls relative to the previous period. This falling trend in the accounts payable turnover ratio may indicate that your company is not able to pay its short-term debt, and is facing a financial crunch.

On the other hand, if your business is considered as taking advantage of discounts on early payments if it is paying its suppliers quickly.

Example of Accounts Payable Turnover Ratio

Robert Johnson Pvt Ltd needs to determine its accounts payable turnover ratio for 2024. It had an opening accounts payable balance of $500,000 and a closing accounts payable balance of $650,000. In addition to this, Robert Johnson Pvt Ltd made purchases worth $6,000,000 during the year.

Therefore, the accounts payable turnover ratio of Robert Johnson Pvt Ltd for 2019 is as follows:

Accounts Payable Turnover Ratio = $6,000,000/(($500,000 + $650,000)/2)

= $6,000,000/$575,000

= 10.43 times

Meaning that Robert Johnson Pvt Ltd paid 10.43 times to its suppliers during the year. You can also calculate the accounts payable turnover ratio in days, this ratio showcases the average number of days after which you make payments to your suppliers.

Thus, the formula for Accounts Payable Turnover Ratio in days is as follows:

Accounts Payable Turnover Ratio in days = 365/Accounts Payable Turnover

= 365/10.43

= 34.98 days

Meaning that Robert Johnson Pvt Ltd made payments to its suppliers after approximately 35 days.

How to Record Accounts Payable?

As accounts payable are deemed short-term obligations of your business towards its creditors or suppliers, these obligations will need to be met in less than a year. Therefore, accounts payable appears on the liability side of your balance sheet, under current liabilities.

Whenever your supplier provides goods or services on credit to your business, there are accounts payable outstanding on your balance sheet. Meaning the accounts payable account gets credited as there is an increase in the current liability of your business.

Since we typically follow a double-entry bookkeeping system, there has to be an offsetting debit entry to be made in your company’s general ledger. Either an expense or an asset forms part of the debit offset entry in the case of accounts payable.

Example of Accounts Payable

If Robert Johnson Pvt Ltd purchased goods worth $200,000 on credit from its supplier. It would record the following journal entry on receipt of goods on credit from its supplier:

When Robert Johnson Pvt Ltd makes payment to its supplier, the accounts payable account gets debited. This is because Robert Johnson’s current liability is reduced by $200,000. The offsetting credit entry for such a transaction is made to the cash account, because the cash worth $200,000 gets reduced.

So, the following is the journal entry for cash paid to the supplier:

How to Record Accounts Receivables?

Let’s consider the above example again to understand how to record accounts receivable.

When Goods are Sold on Credit

If Robert Johnson Pvt Ltd sold worth $300,000 paper to James & Co. on a 45-day period credit. The journal entry at the time the invoice is raised would be as follows:

As a result, debiting accounts receivable with $300,000 means an increase in accounts receivable by the same amount, also crediting the sales account by $300,000 means an increase in sales by the same amount.

When Cash is Received for Goods Sold on Credit

If James & Co. paid $300,000 in cash to Robert Johnson Pvt Ltd within 45 days. The journal entry at the time cash is received for goods sold on credit would be as follows:

As a result, debiting the cash account by $300,000 means an increase in the cash account by the same amount, also crediting accounts receivable by $300,000 means a decrease in the accounts receivable by the same amount.

How to Calculate Accounts Payable?

You can calculate the accounts payable by generating accounts payable aging summary report, if you are using QuickBooks Online Accounting Software. This report provides a summary of all the accounts payable balances, and also lets you know about the balances that are overdue for payment.

If you are not using accounting software, you can calculate your accounts payable by adding the amounts of all the bills that you have maintained physically.

Let's use the balance sheet of Walmart Inc, as of January 31, 2020, as an example. It showcases that the accounts payable of Walmart Inc were $46,973 million in 2020 and $47,060 million in 2019. This means that an investor or an outsider can calculate days payable outstanding in order to know the number of days Walmart Inc takes to clear its accounts payable.

Based on Walmart’s payment schedule, its suppliers can determine the credibility of the company. For example, the suppliers would consider Walmart Inc to be a credible customer if it pays its suppliers within a decent credit period.

The days payable outstanding of Walmart Inc would also help the company in ensuring that it is neither paying too early or too late to its suppliers.

Delaying the payments for a few days would help Walmart Inc to hold more cash to eventually pay to its suppliers. However, delaying payments for too a long of a period would critically impact Walmart’s relationship with its suppliers.

Reducing Accounts Payables

Your business must focus on optimizing its accounts payable to free up working capital in order to enhance business growth. Ineffective accounts payable management can lead to invoices not being processed on time, or losing out on the opportunity to utilize discounts.

The following are some of the strategies that you can adopt to optimize your business’s accounts payable:

Choose Preferred Suppliers

You can set up a list of favored suppliers, this can promote moderate and favorable buying from your suppliers. This kind of list can be developed considering certain factors, including the supplier’s performance, their financial soundness, brand identity, and their capacity to negotiate.

Review Supplier Contracts Regularly

It's essential that you to review your supplier contracts on a regular basis as it helps to prevent fraudulent billing practices, whether due to overpayment or duplicate payments.

To carry out this practice, you'll need to ensure that you have a proper accounts payable team, this team reviews supplier data for its completeness, accuracy, and compliance with standard terms.

You'll also need to include certain clauses in the supplier contract relating to penalizing suppliers, this is in case of non-performance or underperformance.

Pay Accounts Payable Early

Ensuring that accounts payable are paid on time will help strengthen your company’s relationship with your suppliers. In return, the suppliers will likely offer attractive discounts so that you can save more and stay connected with the supplier.

Use Accounts Payable Software

You'll need to ensure that a centralized invoice processing system is in place. Using an online invoicing software, like QuickBooks, will help you automate your accounts payable process by going paperlessm meaning all your company’s bills can be created and sent via the invoicing software.

As a result, there will be no need for you to manually enter or upload all your invoices, and your purchase and payment process would also get automated.

Discounts on Accounts Payable vs Accounts Receivable

If your supplier has determined that you are a credible customer, you may receive early payment discounts on your accounts payable. This means while you're receiving a discount on your accounts payable, you can give a discount on your accounts receivable to customers that make early payments.

Both accounts payable and accounts receivable form an important part of trade credit. It is important for your business to receive trade credit from its suppliers in the form of accounts payable, as it helps finance your production process. However, it is also important to extend trade credit in the form of accounts receivable to sell goods to your customers.

Methods to Pay Early Discounts

There are two methods that can be used to pay and record discounts:

Net Method

With the net method, if you pay your supplier within the agreed-upon time period, you'll get a certain percentage of the discount. This is before the payment becomes due.

For instance, 2/10 net 30 is the trade credit that your suppliers offer for the sale of goods or services, meaning you'll receive a discount of 2% if you pay the amount due within 10 days. Otherwise, the amount gets due within 30 days.

Using the above example, if Robert Johnson Pvt Ltd make a purchase of $10,000 from its supplier James and Co, with a credit term of 2/10 net 30, the journal entry in the books of James and Co would be as follows:

Gross Method

The gross method is used to record the total value of receivables in the event you decide to take advantage of a discount from your supplier. For example, as a result of this method, James and Co. will reduce its revenue in the income statement. The journal entries in the books of James and Co will look as follows:

If Robert Johnson pays James and Co. within 10 days, the journal entry in the books of James and Co would be as follows:

Similarly, the following entry would be showcased in Robert Johnson’s books of accounts:

General Ledger Account: Accounts Payable

Accounts payable is a general ledger account that showcases the amount of money that you owe to your creditors/suppliers. If yo receive an invoice mentioning the payment terms from your supplier, it then gets recorded in your accounts payable ledger. As a result, your total liabilities also increase with the same amount.

Now, the accounts payable represents the short-term debt obligations of your business, meaning they form a part of the current liabilities on your company’s balance sheet. Accounts payable has a credit balance since it is your current liability, so the balance increases if there is a credit entry and decreases if there is a debit entry.

Say, for instance, you receive invoices from your suppliers, these supplier invoices would be recorded as credits to your accounts payable account. These transactions would then increase the credit balance of your accounts payable, so by paying your suppliers in cash, your accounts payable balance will get reduced.

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