Accounts payable is the dollar amount of short-term liabilities owed to other parties.
Current liabilities are business debts that must be paid within a year, and accounts payable balances are current liabilities.
Accounts payable also includes the portion of long-term debt owed within a year.
Balance Sheet Components
A balance sheet provides detail for these categories:
- Assets: Assets are defined as resources that are used to generate revenue (sales) and profits in the business. An asset may be tangible, such as a vehicle, or intangible, such as a patent or other intellectual property.
- Liabilities: Liabilities represent amounts owed to other parties, including accounts payable and long-term debt.
- Equity: Equity (also referred to as stockholder’s equity) is the difference between assets and liabilities. Equity includes common stock, additional paid-in capital, and retained earnings. The equity balance is the true value of a business.
The three components of the balance sheet are driven by the balance sheet formula:
Assets – liabilities = equity
Current vs. Non-Current Accounts
Assets and liabilities are either current or non-current.
A current asset represents cash, or an asset that will be converted into cash within 12 months. Accounts receivable balances (money owed by customers) and inventory are current assets.
Fixed assets, such as machinery and equipment used in a business, are non-current assets, because they will be used for years.
Your accounts payable balance represents bills you must pay within 12 months, and the balance is a current liability. Long-term debts, on the other hand, are non-current liabilities.
Accrual Basis vs. Cash Basis Method
The accrual basis method of accounting requires a business to post revenue when it is earned, and expenses when they are incurred. This method applies the matching principle, which matches revenue with the expenses that relate to producing the revenue. The accrual basis presents a more accurate picture of net income, and this method ignores the timing of cash inflows and outflows.
Accounts payable is used to record an expense in the proper period, and to post a liability for a future payment. Assume, for example, your company hires a technician to repair a machine on March 25th, and the technician’s $3,000 invoice is paid on April 6th. Here are the related journal entries:
|Debit repair expense||$3,000|
|Credit accounts payable||$3,000|
(To record the repair expense and post a liability)
The entry posts the expense in March, when the expense is incurred. You post a second entry when the invoice is paid:
|Debit accounts payable||$3,000|
(To remove the liability and record the cash payment)
The cash is paid in April, but the expense is correctly recorded in March.
Accounts Payable and Its Impact on Liquidity
Liquidity measures a firm’s ability to produce enough current assets to pay current liabilities, including accounts payable. Analysts use the working capital and the current ratio to assess a company’s liquidity.
Assume that your firm has $150,000 in current assets and a current liability balance of $120,000. Here is the working capital calculation:
Working capital = $150,000 in current assets – $120,000 current liabilities = $30,000
Your goal is to maintain a positive working capital balance, so that you have enough current assets to pay all current liabilities.
You can also evaluate liquidity using the current ratio:
Current ratio = $150,000 in current assets / $120,000 current liabilities = 1.25
If you use the current ratio, your goal is to maintain a ratio of 1.0 or higher.
Using these methods will help you to develop a better understanding of your company’s Assets, Liabilities and Equity, and strengthen your ability to plan for the future.