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Accounts Payable (A/P)

Guide to Understanding Accounts Payable (A/P)

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Accounts Payable (A/P)

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 DPO = Accounts Payable ÷ Cost of Goods Sold x 365 Days

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.

Forecasted Accounts Payable = (DPO Assumption ÷ 365) x COGS

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Accounts Payable Calculator – Excel Template

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Accounts Payable Calculation Example

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.

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.

  • Cost of Goods Sold (COGS) = $200 million
  • Accounts Payable, BoP = $50 million
  • Change in A/P = +$10 million
  • Accounts Payable, EoP = $60 million

For Year 0, we can calculate the days payable outstanding with the following formula:

  • DPO – Year 0 = $60m ÷ $200m x 365 = 110 Days

As for the projection period, from Year 1 to Year 5, the following assumptions will be used:

  • COGS – Increase by $25m/Year
  • DPO – Increase by $5m/Year

Now, we’ll extend to 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 in which 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.

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.

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