EBITDA and Other Scary Words: Scary Words No.8 - Accounts Payable
All the way back in installment number two, we explained the balance sheet and how it is a snapshot of the assets, liabilities and owner’s equity at a specific date. Just as the title states, the balance sheet balances. The formula is assets = liabilities + equity.
We have had several articles on the asset side of the balance sheet so now we will be moving on to the second part of the equation, liabilities.
Accounts Payable as a Liability
As a business owner (we’ll use bar owner to keep things consistent) some of the items you will need to purchase include inventory for sale (liquor and beer), supplies (drink stirrers and napkins), utilities and cleaning services. The good news is most vendors and service providers will grant you payment terms so you don’t have to pay for everything as it is delivered.
But, you do have to keep track of all the payments due to your vendors. These outstanding payments are called Accounts Payable, or AP.
Nearly all of your purchases and services will go through accounts payable so it is important to understand this liability. AP can be broken down into two categories – trade payables and expense payables. Trade payables are generally for the purchase of goods that are included in inventory and subsequently sold (liquor and beer). Expense payables include goods or services that are expensed such as supplies, utilities and cleaning services. AP is a current liability and is usually one of the first liabilities listed on the balance sheet.
So what can you do as a business owner to ensure you are effectively managing AP?
Many of the following items are similar to our previous article on Accounts Receivable. That’s because AR and AP are closely linked. On the AR side you are selling goods and services in exchange for a future cash receipt. On the AP side you are receiving goods and services in exchange for a future payment.
Review AP Aging Reports:
Many software platforms will automatically produce AP aging reports. The AP aging report is a very useful tool that will help you evaluate your payables. The report will usually display unpaid invoices in aging buckets such as “current,” “30 days past due,” “60 days past due” and “over 90 days past due.” By doing a detailed review of this report you can determine which invoices should be paid and which invoices can wait. You should also identify any vendors that provide discounts for prompt payment and try to take advantage of the savings. For example, payment terms could include a small discount if paid within 10 days or some other short period.
Keep it simple:
Try to pay your AP only once or twice per month instead of making a few payments each day. Paying your AP sounds simple but it can be time-consuming You must review the AP aging, evaluate your available cash, and then select items for payment. Doing all of this takes up your valuable time so it should only be done once or twice per month. To maintain good controls over the cash, you should either be reviewing and approving the disbursements or signing the checks.
AP turnover ratio:
The AP turnover ratio estimates how many times a year a company’s AP is paid. The lower the turnover rate, the longer payables are outstanding and you may be getting charged late payments penalties or interest. To calculate this ratio, take your net purchases for a period of time and divide them by the average AP for the same period. For example let’s say you have the following:
Net purchases or cost of sales for the year — $40,000, AP beginning of the year — $3,000, AP end of the year — $3,400
40,000 divided by (3,000+3,400)/2 = 12.50
Your AP turnover ratio is 12.50 for the year. So on average, in this example, payments of AP are approximately 12 times a year or once per month.
Days in Accounts Payable:
The days in AP ratio indicates how long it takes the entity to pay its invoices or the number of days an invoice is outstanding. The higher the ratio, the longer it takes for you to make payments on purchases. This can be an indicator that you need to better manage your cash flow or evaluate your purchases and sales to make sure they are in line with each other. To calculate this ratio, you divide the number days in the period by the AP turnover ratio from above, like so:
365 divided by 12.50 = 29.20
In this example AP is being paid just before the usual deadline of 30 days. In this scenario, it would probably be a good idea to review vendors’ payment terms to see if there are any prompt payment discounts to take advantage of. To really stretch out the payment terms you can use a credit card for most vendors. If you pay the vendor with a credit card after 30 days, and then the credit card payment is not due for another 30 days, you have just extended payment for 60 days. And you can earn a bunch of points or miles on your credit card.
To be effective, monitoring of the Accounts Payable and the above ratios should be done throughout the year. Look for trends that could be seasonal or related to other external factors like new neighbors or competitors. Industry averages and ratios can be very helpful as a benchmark for your company. Our firm, and most other accounting firms, have databases of industry information and industry experience that could help with your analysis.
Nearly every expense your business incurs will flow through accounts payable. It is vital to the success of your business to closely monitor your payables and evaluate the best time to actually pay them. Plus with a lot of charges to your credit card you should have enough miles for a nice trip.
"This article originally appeared on Financial Poise and is reprinted here with permission."
- EBITDA and Other Scary Words: What Did They Just Say?
- Scary Word No. 1 – GAAP
- Scary Word No. 2 – Financial Statements
- Scary Word No. 3 – Cash
- Scary Word No. 4 – Accounts Receivable
- Scary Word No. 5 – Inventory
- Scary Word No. 6 – PP&E
- Scary Word No. 7 - 'Intangible' Assets
- Scary Word No. 8 - Accounts Payable
- Scary Word No. 9 - Accrued Expenses
- Scary Word No. 10 - Commitments and Contingencies
- Scary Word No. 11 - Debt, Collateral, Covenants, Guarantees and More
- Scary Word No. 12 - "The Deferreds"
- Scary Word No. 13 - "Equity"