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.
Accounts Payable: Definition in Accounting (A/P)
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, increase 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 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.
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: Current Liability on Balance Sheet
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.
How to Forecast Accounts Payable (Step-by-Step)
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: Methods to Extend Payables (DPO)
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
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.