Accounts Payable (A/P)

What is the Definition of Accounts Payable?

Under accrual accounting, the accounts payable (A/P) line item on the balance sheet records the cumulative payments due to 3rd parties, such as suppliers and vendors.

Accounts payable, often abbreviated as “payables” for short, represent invoiced bills to the company that have not been paid off.

Therefore, accounts payable (A/P) is classified in the current liabilities section of the balance sheet, as unfulfilled payment obligations imply a future outflow of cash.

Expenses must be recorded once incurred per accrual accounting standards, which means when the invoice was received, rather than when the company pays the supplier/vendor.

In effect, the accounts payable balance 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.

Is Accounts Payable a Current Liability?

The relationship between accounts payable and the free cash flow (FCF) of a company is as follows:

• Increase in Payables (A/P) → 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 Payables (A/P) → Eventually, the suppliers/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 A/P is reflected as an “inflow” of cash on the cash flow statement, while a decrease in A/P is shown as an “outflow” of cash.

Accounts Payable vs. Accounts 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.

Hence, while accounts payables are recognized as a current liability, accounts receivables are recorded in the current assets section of the balance sheet.

• Accounts Payable (A/P) → To reiterate from earlier, payables are 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, receivables 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 Formula (A/P)

To project a company’s accounts payable (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.

How to Forecast Accounts Payable?

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

For example, if a company’s COGS are predominately inventory orders for raw materials directly involved in production.

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/service from the supplier or vendor.

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

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

How Does the Accounts Payable Process Work?

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:

• 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 Calculator

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.

• Accounts Payable, BoP = $50 million
• Change in A/P = +$10 million
• Accounts Payable, EoP = $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 x 365 = 110 Days

2. Accounts Payable Calculation Example

As for the projection period – from Year 1 to Year 5 – we’ll use the following assumptions:

• Cost of Goods Sold (COGS) → Increase by $25m/Year
• Days Payables Outstanding (DPO) → Increase by $5m/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:

• Year 1 A/P = 115 ÷ 365 x $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 schedule.

The change in A/P subtracts the ending balance in the current year from the prior year’s 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.

In conclusion, 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.