What is Accounts Payable (AP)?

Accounts payable is like a company’s stack of bills…

Just as you may have a stack of bills on your nightstand — phone, electric, doctor — a company does as well. Those bills need to get paid and count against other items on its balance sheet.

The accounts payable department in a company is responsible for managing and paying the invoices. In some smaller companies, the department handles both accounts payable and accounts receivable, which are monies owed to the company.

This department typically handles three aspects of a company’s financials:

1. Vendor payments: When a company orders supplies or services from a vendor, that vendor will typically issue an invoice as soon as the goods are delivered. The invoice becomes part of the accounts payable. The accounts payable department receives the invoice and pays it when it becomes due.
2. Managing terms: Most vendors and suppliers offer special terms to companies that pay invoices early. For example, some vendors offer a discount if an invoice is paid within the first 10 days. The accounts payable department may manage these terms in several ways. For instance, they may negotiate the best terms with each vendor.
3. Internal payments: Some accounts payable departments also handle internal payments. For example, it may manage the petty cash fund or handle employee reimbursements for out of pocket expenses.

Most accounts payable departments have specific procedures in place to ensure on-time payment of invoices. These procedures also reduce the risk of inaccuracies or double payments. Here is an example of the steps most accounts payable departments take:

• Review the invoice: When the department receives an invoice, they will review it to ensure that the company received what is reflected on the invoice. They will also check that the vendor name, address, and payment methods are up-to-date and accurate.
• Credit the ledger: When the department receives the invoice, it adds a credit to the accounts payable balance. The more outstanding invoices a company has, the higher the accounts payable balance.
• Make the payment: All invoices have a due date, and some include terms for invoices paid early. It’s up to the accounts payable department to pay each invoice as it comes due.

For each credit to the accounts payable balance, the accountant will have to create a debit to offset it. This practice is called double-entry bookkeeping. This system allows for a clearer insight into the company’s financial health.

For example, if a bakery received an invoice from a contractor for services, it would credit the accounts payable for that amount. But to offset that credit, the company would log a debit to the contractor services expense. Then, once the invoice is paid, a credit is issued to the company’s bank account, and a debit is issued to the accounts payable. In other words, the accounts payable balance goes down when an invoice is paid.

When a company makes purchases on credit, the amount is credited to the accounts payable balance. The more that balance increases, the more the company owes. When the invoice is paid, that amount is debited from the accounts payable balance, resulting in a decrease in the amount owed.

Accounts payable is usually shown as a credit, as this represents the amount the business owes to others. If it was a debit, it would indicate that suppliers have been overpaid, and the balance should be reclassified to accounts receivable (the money is now owed back to the company).

Accounts payable is a liability on a company’s balance sheet. That’s because it’s money the company owes someone else, so the balance owed is deducted from the company’s bottom line. Imagine that you gave your friend an IOU for your share of a restaurant meal. That IOU is a liability to your finances until you pay back your friend.

Accounts payable and accounts receivable are the exact opposite. When a company buys something from a vendor on credit, it is logged onto the balance sheet as accounts payable. But when a customer (or another business) purchases something from that company on credit, it is logged onto the balance sheet as accounts receivable.

In other words, accounts payable is when a company owes money and accounts receivable is when someone owes money to the company.

You may hear people use the terms accounts payable and trade payables interchangeably, but there is a slight difference in them. Accounts payable are short-term debt obligations, while trade payables are debts incurred only for inventory-related goods or services consumed in regular business operations.

Trades payable is a type of accounts payable – So anything that is trades payable is accounts payable. Still, not everything that is an accounts payable item is considered trades payable.

For example, if a bakery purchases ingredients to make their products, that debt is considered trade payables because it is related to its inventory. The business consumes these items to make the products it sells. But when the bakery buys a new back-office computer on credit, that debt is not considered a trade payable – It would be recorded under accounts payable.

Since trade payables is a subset of accounts payable, some companies prefer to combine these expenses and put them all in accounts payable, while others prefer to keep them separate.

Accounts payable is an indicator of a company’s fiscal health. It must be suitably managed to make the best use of the company’s cash flow. If the accounts payable climb too high and too fast, it could be an indicator of trouble. But sometimes as businesses grow, the accounts payable increases to reflect the demand for products or services.

Analysts use two metrics to measure a company’s cash flow and ability to meet its short-term debt obligations. Both of these metrics use the cost of goods sold from the income statement and the accounts payable from the balance sheet.

1. Accounts Payable Turnover (APT): This metric measures liquidity by determining how many times a company pays its accounts payables in an accounting period. To arrive at this figure, divide the cost of goods sold (from the income statement) by the accounts payable. The resulting ratio is the number of months it takes to pay the total accounts payables. If the ratio is high, it could mean that the company isn’t holding onto its funds long enough to earn interest, or that it’s having a hard time obtaining credit. If it’s low, it could mean that the company is paying its invoices slowly or that it has negotiated extended terms with its vendors.
2. Days Payable Outstanding (DPO): This metric measures efficiency by determining how many days a company takes to pay off its suppliers on average. To get this figure, divide the accounts payable amount by the cost of goods sold and then multiply by the number of days in an accounting period.