When you think of cash management, your first thought may be to increase collections from accounts receivable. Accounts payable, however, is another huge factor in cash management. This discussion defines accounts payable, and how to set up an effective process for accounts payable management.
What is accounts payable?
The accounts payable balance includes bills and other liabilities that must be paid over the next few months. Accounts payable is a component of the liabilities balance in the balance sheet equation:
Asset less liabilities equals equity
Balance sheet accounts are separated into current and non-current accounts.
Accounts payable is a component of current liabilities, which are obligations that must be paid within the next 12 months. Current liabilities also include:
- Trades payable: Some firms use trades payable to record bills received from suppliers. Other companies post the supplier invoices to accounts payable, and don’t use the trades payable account.
- Short-term debt: The principal and interest due on a loan are posted to current liabilities. If a firm owes $4,500 in principal and interest over the next 12 months, the balance is a current liability.
- Credit card balances: Amounts due on credit cards are posted to current liabilities.
Non-current liabilities are debts that are due in a year or longer. Most of the balance on a five-year loan, for example, is categorized as a long-term (non-current) liability.
The financial statements also include current assets, which include cash, and balances that will be paid within 12 months. Accounts receivable and inventory are current assets. A fixed asset, such as machinery, is a non-current asset account.
The accounts payable balance impacts your firm’s cash flow.
Impact of cash flow
Business owners must monitor the accounts payable balance, and use a cash forecast to plan the payments. A company’s cash position is important, because every firm needs a minimum cash balance to operate. Owners must consider the timing of cash inflows from account receivable and the cash outflows required for accounts payable.
To manage cash flow, create a monthly cash flow rollforward, using these line items:
- Beginning cash balance
- Cash inflows from accounts receivable, other sources
- Cash outflows for accounts payable, inventory purchases, and payroll
- Ending cash balance
The ending cash balance in March is the beginning cash balance in April. Review your company’s balance sheet, and analyze each asset and liability account to determine the impact on cash flow.
To work productively, you need to design an efficient system to manage the payment process.
What is the accounts payable process?
To effectively manage accounts payable, you must post transactions using the accrual basis of accounting.
Accrual accounting requires firms to post revenue when earned, and expenses when incurred to generate revenue. All businesses should use accrual accounting, so that revenue can be matched with expenses, regardless of the timing of cash flows.
The accounts payable department should use accrual accounting to post transactions, and for financial reporting. To set up a clearly defined process, meet with your AP department. If your firm is smaller, a bookkeeping employee may handle accounts payable.
Your payable system should include these components:
Most spending decisions must require a purchase order, or PO. Assume, for example, that Acme Manufacturing needs to order a $10,000 piece of machinery. Before the order is placed, the plant manager must complete a PO, which lists the machinery’s price and other details.
The owner, or someone else with financial responsibility (CFO), approves the PO. At this point, the order can be placed. Small purchases, such as $40 in office supplies, don’t need a PO. Purchase orders help a business control spending.
When the order is placed, the vendor will send an invoice. The person responsible for account payable tasks should record the following information in the accounting system:
- Due date
- Payment terms: Some vendors offer a discount, if the invoice is paid within 5-10 days. If a discount is offered, you may decide to pay the invoice in a shorter period of time.
- Contract information: Name, address, email, client’s invoice number. If the vendor takes electronic payments, include that information with the invoicing data.
- Purpose: If you need to plan the payment for machinery, include a description of the purchase.
When the item is received, the vendor should include a shipping receipt.
The shipping receipt details what the vendor sold to the customer. The receipt includes a description, and the number of items included in the shipment.
The data on the purchase order, invoice, and shipping receipt should be the same. Reviewing these documents ensures that the order was approved, and if you received the goods that were ordered.
If the data matches, the accounting department can generate a check. The owner should review all of the documents before signing the check and paying the invoice.
Automate the payable process to save time and to reduce the rate of error. You can purchase accounting systems that can scan receipts and invoices, so they can be electronically linked to a particular transaction.
In addition to managing paperwork, you need to post accounting entries.
General ledger entries
The accounts payable department posts journal entries into general ledger. A journal entry contains all of the information needed to record a transaction. Here are two common journal entries for accounts payable.
Purchase on credit
When Acme Manufacturing places the order for the $10,000 piece of machinery on March 5th, it posts this journal entry:
Debit #3100 machinery (asset account) $10,000
Credit #5000 accounts payable $10,000
(To record the March 5th purchase of machinery on credit)
Acme posts a debit to increase the machinery asset account (#3100), and posts a credit to increase accounts payable (#5000).
The journal entry includes the date, accounts, dollar amounts, debit and credit entries, and a description of the transaction.
When the invoice is paid, the accounts payable balance is decreased.
Invoice paid in cash
Acme Manufacturing pays the invoice on April 6th, and posts this journal entry:
Debit #5000 accounts payable $10,000
Credit #1000 cash $10,000
(To record the April 6th invoice payment)
Acme posts a debit to decrease accounts payable (#5000), and a credit to reduce cash (#1000).
There are a number of tools you can use to improve the accounts payable process.
Management tips for accounts payable
You should monitor accounts payable, and make changes to improve your business. Here are two valuable metrics for accounts payable management.
Accounts payable turnover
Purchases on credit increase the accounts payable balance. Accounts payable turnover is (total purchases on credit) divided by (average accounts payable balance). The period measured is typically a month or year.
Let’s assume that a business buys a large dollar amount on credit in March, and pays the invoices right away. The March purchase balance is high, but the average accounts payable balance may only be a few days. If you increase the accounts payable turnover ratio, you’re paying for credit purchases faster.
To conserve cash, you may want to take more time before you pay invoices. If most of your invoices are due within 30 days, you can delay payment until you collect more money from customers.
The accounts payable aging schedule is another great tool to manage payables.
Accounts payable aging schedule
An aging schedule separates accounts payable balances, based on the number of days since the invoice was issued. Acme Manufacturing, for example, has $100,000 in payables from 0 to 30 days old, and $15,000 due in the 31 to 60 day category.
The aging schedule helps you decide when invoices must be paid. The vast amount of your payables should be in the 0 to 30 days old category. Since most invoices are due within 30 days, you don’t want many outstanding invoices unpaid beyond 30 days.
If you wait too long to pay, you may damage the relationship with the vendor. Reliable vendors are important, and you need to pay them in a timely manner.
Take action to manage accounts payable.
Review your systems for managing accounts payable, and use technology to automate the process. Use QuickBooks accounting software to scan invoices, post payables into your accounting system, and to pay invoices electronically.
Use the ratios discussed above to conserve cash, and maintain good relationships with your vendors. Take charge of the accounts payable process, to improve your business results.