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 payables?
- Are accounts payables an asset or liability?
- How does an increase in accounts payables affect cash flows?
- How does a decrease in accounts payables impact cash flows?
Table of Contents
Accounts Payable Definition
Under accrual accounting, the accounts payable (A/P) line item on the balance sheet records the cumulative payments due to third parties such as suppliers and vendors.
Accounts payable, often referred to as “payables” for short, 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.
A/P represents invoiced bills to the company that have 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.
Under accrual accounting, expenses are recorded once incurred, which means when the invoice was received, rather than when the company pays the supplier/vendor.
Accounts Payable – Accounting Process
The relationship between accounts payable and the free cash flow (FCF) of a company is as follows:
- Increase in 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 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.
Projecting 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.
Sources of Buyer Power
- 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
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.
The formula for days payable outstanding (DPO) is as follows.
Historical DPO = A/P ÷ Cost of Goods Sold x 365 Days
When projecting accounts payable, historical trends are used as a reference, or an average can be taken with the industry average used as a reference.
Using DPO, the projected accounts payable is equal to:
Projected A/P = (DPO Assumption ÷ 365) x COGS
Accounts Payable Calculator – Excel Template
We’ll now move to a modeling exercise, which you can access by filling out the form below.
Accounts Payable Example Calculation
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.
At the beginning of the period, the accounts payable balance was $50 million but the change in AP was an increase of $10 million, so the ending balance is $60 million in Year 0.
For Year 0, we can calculate the days payable outstanding with the following formula:
DPO – Year 0 = $60m / $200m * 365 = 110 Days
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 to assumptions across 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 * $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 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.