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Accounts Payable (AP)

Step-by-Step Guide to Understanding Accounts Payable (AP)

Last Updated May 27, 2024

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Accounts Payable (AP)

In This Article
  • Accounts payable is a current liability on the balance sheet representing unpaid bills owed to suppliers and vendors for products or services received on credit as opposed to cash.
  • Accounts payable is created when a company receives goods or services from a supplier but delays payment, causing a higher AP balance.
  • The formula to calculate accounts payable is equal to the beginning AP balance plus credit purchases, subtracted by supplier payments.
  • In terms of the journal entry, the accounts payable account is credited when the current liability increases and debited upon issuance of the cash payment, with the credit balance reflecting the remaining balance.
  • The accounts payable of a company is considered a current liability since the payment obligation must be settled at some point (“cash outflow”).
  • If a company’s accounts payable balance rises, the delay implies an improvement in its near-term cash flow, while a decreasing payables balance means paying vendors (and reduction to cash flow).

How to Calculate Accounts Payable

Accounts payable (AP) refers to the short-term obligations that a company owes to its suppliers or vendors for goods and services paid for on credit, rather than cash.

The accounts payable line item is recorded in the current liabilities section of the balance sheet and must be paid off within a specified period, most often within 30 to 90 days.

Accounts payable represents a current liability that measures the unmet payment obligations still owed to suppliers and vendors by a particular company.

The recognized accounts payable balance on a company’s balance sheet reflects the cumulative unmet payments due to 3rd party creditors, namely suppliers and vendors, under accrual accounting.

In effect, the accounts payable balance increases when a supplier or vendor extends credit, and vice versa when the company pays in cash (and fulfills the payment obligation to its creditors).

If a company were to place an order to purchase a product or service, the expense is accrued, despite the fact that the cash payment has not yet been paid.

The process of calculating the ending accounts payable balance for a given period is as follows:

  • Step 1 ➝ Determine Beginning Accounts Payable
  • Step 2 ➝ Add Credit Purchases
  • Step 3 ➝ Subtract Supplier Payments

Accounts Payable Definition

Accounts Payable Definition (Source: LII Wex)

Accounts Payable Formula

The formula to calculate accounts payable starts with the beginning accounts payable balance, adds credit purchases, and subtracts supplier payments.

Ending Accounts Payable = Beginning Accounts Payable + Credit Purchases Supplier Payments

Where:

  • Ending Accounts Payable ➝ AP Balance at Beginning of Period
  • Beginning Accounts Payable ➝ AP Balance at End of Period
  • Credit Purchases ➝ Non-Cash Purchases on Credit
  • Supplier Payments ➝ Payments Issued to Suppliers

If a company pays its suppliers and vendors in cash immediately upon receipt of the invoice, the accounts payable balance would be near zero.

But companies are incentivized to retain the cash on hand for as long as possible.

Why? The cash on hand can be spent on reinvestments, to fund day-to-day working capital needs, and meet unexpected payment obligations.

If a company’s accounts payable balance grows, the company’s cash flow increases (and vice versa) — albeit, the obligation to pay in-full using cash is mandatory.

Accounts Payable vs. Receivable: What is the Difference?

On the balance sheet, the accounts payable (A/P) and accounts receivable (A/R) line item are conceptually similar, but the distinction lies in the perspective (i.e. point of view).

Hence, while accounts payable is recognized as a current liability, accounts receivable is recorded in the current assets section of the balance sheet.

  • Accounts Payable (AP) ➝ The accounts payables (AP) measures the unmet payment obligations owed to third-parties, such as suppliers and vendors, for goods or services already received.
  • Accounts Receivable (A/R) ➝ In contrast, accounts receivables (A/R) are the payments that customers owe to a company for products or services already delivered to them, i.e. an “IOU” from customers who paid in the form of credit, rather than cash.

Accounts Payable Journal Entry: Debit or Credit

For bookkeeping purposes, accounts payable (AP) is recognized as a liability account that maintains a credit balance, barring unusual circumstances.

Upon receipt of an invoice, the company records a “credit” in the accounts payable account with a corresponding “debit” in the expense account.

Suppose a business purchases $20k in inventory and agrees to pay the supplier on a later date, rather than the present date.

The impact of the transaction is a debit entry to the “Inventory” account, with a credit entry to the “Accounts Payable” account, reflecting the increase in the current liability balance.

  • Inventory (Raw Material) ➝ Debit
  • Accounts Payable (AP) ➝ Credit
Journal Entry Debit Credit
Inventory (Raw Material) $20,000
       Accounts Payable (AP) $20,000

Once the payment is made, the accounts payable account is debited, and the cash account is credited.

Journal Entry Debit Credit
Accounts Payable (AP) $20,000
       Cash $20,000

If a company is owed more payments in the form of cash from customers that paid using credit, the “Accounts Payable” account is credited to reflect the increased obligation.

Conversely, if the company is the party that owes cash to a supplier or vendor, the issuance of the payment to settle these debt is recorded as a debit on the “Accounts Payable” account.

The credit balance reflects the total amount the company still owes to its suppliers or vendors for goods or services received but not yet paid for.

Is Accounts Payable a Current Liability?

The accounts payable (AP) line item is recognized as a current liability on the balance sheet prepared under US GAAP reporting standards.

Expenses must be recorded once incurred per accrual accounting standards, so the timing of the recognition is the period in which the invoice is received, rather than when the company paid the supplier or vendor.

Therefore, accounts payable is classified in the current liabilities section of the balance sheet, as unfulfilled payment obligations imply a future “outflow” of cash.

The outstanding obligation to fulfill the payment in the form of cash to the supplier or vendor for the product or service received is anticipated to be paid in-full within the next 30 to 90 days.

Accounts Payable Example on Balance Sheet

Accounts Payable Example on Balance Sheet (Source: Alphabet, Inc. 10-Q)

How to Improve Accounts Payable Collection

The relationship between accounts payable (AP) and free cash flow (FCF) is as follows:

  • Increase in Accounts Payable (AP) ➝ The company has delayed the issuance of payments to its suppliers or vendors, where the cash remains in the possession of the company in the meantime.
  • Decrease in Accounts Payable (AP) ➝ Eventually, the suppliers or vendors will be paid with cash, which will cause the outstanding accounts payable balance to decline.

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 accounts payable is reflected as an “inflow” of cash on the cash flow statement, while a decrease in accounts payable is shown as an “outflow” of cash.

From the perspective of suppliers and 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:

  • Higher Order Frequency ➝ Large Order Volume on a Frequent-Basis
  • Increase Order Size ➝ Large Order Size on a Dollar-Basis
  • Improve Customer Trust ➝ Long-Term Relationship with Customer (i.e. Consistent Track Record)
  • Limited Competition ➝ Smaller-Sized Market with Fewer Potential Customers

What is the Accounts Payable Process?

The standard accounts payable cycle is characterized by three steps (and coinciding documents):

  1. Purchase Order (PO) ➝ The purchase order (PO) is a formal document sent by the buyer to the seller stating the commitment to pay for the goods or services expected to be received.
  2. Receiving Report ➝ The receiving report, or “goods receipt”, is a document intended to confirm the receipt of goods or services from a supplier for record keeping purposes.
  3. Vendor Invoice ➝ The vendor invoice, or “bill”, is a document that a supplier or vendor issues to a customer that purchased goods or services (and now has the obligation to pay).

Starting off, the accounts payable process initiates after a company’s purchasing department issues a purchase order (PO) to a supplier or vendor.

The purchase order (PO) document specifies the desired merchandise, quantities, and prices, and serves to initiate the order transfer (i.e. the goods move from the supplier to the customer).

Upon receipt of the goods, the company records the details of the shipment, including any discrepancies in quantity and damage via a receiving report. For example, the purchased items could have arrived in poor condition or the wrong quantity could have been sent.

Once received and processed, the vendor issues an invoice to the company, requesting payment for the goods or services delivered.

The invoice is received by the accounts payable (AP) department of the company, marking the conclusion of the invoice management process.

How to Forecast Accounts Payable

The days payable outstanding (DPO) measures the number of days it takes for a company to complete a cash payment post-delivery of the product or service from the supplier or vendor.

Days Payable Outstanding (DPO) = (Average Accounts Payable ÷ Cost of Goods Sold) × 365 Days

Historical trends are used as a reference, or an average can be taken of comparable industry peers to derive a benchmark for reference.

With that said, the formula for the projected accounts payable balance using the company’s days payables outstanding (DPO) assumption is as follows.

Forecasted Accounts Payable = (DPO Assumption ÷ 365 Days) × COGS

To elaborate on the forecasting of the accounts payable line item in financial modeling, AP is usually tied to COGS in most models, especially if the company sells physical goods.

For example, if a company’s cost of goods sold (COGS) are predominately inventory orders for raw materials directly involved in production.

The average accounts payable is equal to the sum of the beginning and ending AP balance divided by cost of goods sold (COGS), multiplied by 365 days.

Common examples of real-life companies with significant buyer power include Amazon (AMZN) and Walmart (WMT).

What is a Good Accounts Payable?

The accounts payable metric, by itself, offers minimal insights into the operating efficiency of a company.

Hence, the necessity to calculate the days payable outstanding (DPO) of a company, for historical and forecasting purposes.

The historical DPO of a company serves as a practical benchmark by which a company’s management of payables can be analyzed.

The general rules of thumb pertaining to the trend of a company’s days payable outstanding (DPO) is as follows:

  • Rising Days Payable Outstanding (DPO) ➝ If DPO rises, the upward trend implies the company is obtaining more buyer power (and negotiating leverage).
  • Declining Days Payable Outstanding (DPO) ➝ If DPO declines, the downward trajectory implies there is more bargaining power of a supplier.

In short, a higher days payable outstanding (DPO) is often indicative of a company’s operations becoming more efficient, since its free cash flow (FCF) improves.

However, the underlying cause of the rising DPO must be identified, because the increase should stem from improvements in the company’s negotiating leverage with suppliers.

If the DPO of a company is rising from the inability to meet the payment obligations, that is a cause for concern (and can lead to insolvency).

How to Calculate Accounts Payable Turnover Ratio

The accounts payable turnover ratio, or AP turnover ratio, is an operational metric that measures the efficiently at which a company pays off its suppliers and creditors over a specific period.

The AP turnover ratio is a short-term measure of liquidity that tracks the rate at which a company settles its accounts payable (i.e. fulfill unmet payments), reflecting the company’s ability to manage its short-term obligations.

The accounts payable turnover ratio quantifies the number of times a company pays off its accounts payable across a given period, most often a year (i.e. 12 months).

The formula to calculate the accounts payable turnover ratio is equal to the total supplier payments divided by the average accounts payable balance.

Accounts Payable Turnover Ratio = Total Supplier Purchases ÷ Average Accounts Payable

Where:

  • Total Supplier Purchases ➝ The total amount spent on credit purchases from suppliers.
  • Average Accounts Payable ➝ The average AP is the sum of the beginning and ending accounts payable balances for the period divided by two.

Accounts Payable Calculator — Excel Template

We’ll now move to a modeling exercise, which you can access by filling out the form below.

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1. Balance Sheet Assumptions

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.

  • Cost of Goods Sold (COGS) = $200 million

At the beginning of the period, the accounts payable balance was $50 million, but the change in A/P was an increase of $10 million, so the ending balance is $60 million in Year 0.

  • Beginning Accounts Payable = $50 million
  • Change in AP = +$10 million
  • Ending Accounts Payable = $60 million

For Year 0, we’ll calculate our company’s days payable outstanding (DPO) using the following formula:

  • Days Payables Outstanding (DPO) – Year 0 = $60m ÷ $200m × 365 = 110 Days

Accounts Payable Calculation Example

2. Accounts Payable Calculation Example

For the forecast period—from Year 1 to Year 5—we’ll set a step function, wherein cost of goods sold (COGS) and days payables outstanding (DPO) will increase by a fixed amount per year.

  • Cost of Goods Sold (COGS) ➝ Increase by $25 million per Year
  • Days Payables Outstanding (DPO) ➝ Increase by $5 million per Year

Now, we’ll extend the assumptions across our forecast period 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:

  • Accounts Payable (Year 1) = (115 ÷ 365 Days) × $225 million = $71 million
  • Accounts Payable (Year 2) = (120 ÷ 365 Days) × $250 million = $82 million
  • Accounts Payable (Year 3) = (125 ÷ 365 Days) × $275 million = $94 million
  • Accounts Payable (Year 4) = (130 ÷ 365 Days) × $300 million = $106 million
  • Accounts Payable (Year 5) = (135 ÷ 365 Days) × $325 million = $120 million

Starting from Year 0, the accounts payable balance doubles from $60 million to $120 million by the end of Year 5, as captured in the AP roll-forward schedule.

The change in accounts payable subtracts the ending balance in the current year from the prior year’s balance.

Change in Accounts Payable (AP) = Ending Accounts Payable Beginning Accounts Payable

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 (AP) roll-forward schedule represents the outstanding payments owed to suppliers or vendors.

In closing, the remaining payment obligation flows into the accounts payable line item on the company’s balance sheet for the current period.

Accounts Payable Calculator

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Priti
October 27, 2023 10:54 am

Very Helpful and Simple to understand.

Brad Barlow
October 27, 2023 2:30 pm
Reply to  Priti

Thanks, Priti, glad to hear it!

HELENA
December 1, 2022 12:39 pm

Good!!

Brad Barlow
December 2, 2022 4:01 pm
Reply to  HELENA

Glad you found it helpful!

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