The roles of accounts payable in managing working capital has always been overlooked by many businesses. The main reason for this oversight is the fact that many business organization do not deem it fit to employ an expert that would stir the accounts payable administrative functions of the entity. A research that I did during my undergraduate dissertation revealed that most small and medium sized businesses do not appreciate the importance and roles of managing accounts payable function. The dangers of not managing your trade credit could have similar effect of improper cash management on a business.
This article is written to enlighten those that have been ignorant of the vital role played by accounts payable in reaching optimal working capital management which every company strives for. Before I go on discussing the important roles of accounts payable, it would be appropriate if working definition and explanation of the two phrases –accounts payable and working capital management– are provided. Working capital management is discussed in another article so as not to make this post too long, follow the link above to read up that. Hence,
WHAT IS ACCOUNTS PAYABLE?
Accounts payables otherwise known as trade creditors are the amount owed by a business to its suppliers for products or services used as part of completing the business process of an entity. Accounts payables are classed as current liabilities excluding accruals and other non-trade related creditors, e.g, amounts owed to the tax authority. When granting credits, a business relies on the five Cs (Capital, Character, Capacity, conditions and collaterals) of credit scoring to distinguish between customers that will potentially pay and customers that will default in payment.
Taking trade credit is a normal norm of both ancient and modern day business. It is difficult to find a business venture that does not have one form of accounts payable or the other awaiting repayment. The reason for this is because of the fact that accounts payable or trade credit is a cheap source of finance as suppliers rarely charge interest.
Accounts payable process
In as much as the process of handling accounts payables is fairly standardised, organizations have the right to set up a process that best suits its operations. The processes of handling accounts payable are listed in pullet form bellow:
- Documents dated, stamped and sorted using accounting coding system of the company as designed by the accounting information unit of the business. This is to separate the purchases that relates to purchases from those that does not relate to purchases.
- Documents are prioritised
- Documents are segregated
- Invoices are vetted for validity.
- Documents are forwarded to the appropriate unit for processing based on the level of priority.
Accounts payable functions
The whole effort of accounts payable officer or administrator is to attain the following three results for the company:
- Attainment of satisfactory credit from suppliers
- Extending credits during periods of cash shortage
- Maintaining good relations with key customers of the organisation
To achieve the above three functions of accounts payable administrator, an evaluation of whether or not to accept a discount is made. If the benefit of accepting discount to make an early payment outweighs the benefits of paying at a later date, then the trade credit should be paid out as at when due and vice versa. However, other factors that are non financial in nature needs to be considered. Things like what settling a credit on time will do to the reputation of the organization. Typically, the financial cost of making payments on your accounts payable on a later day outweighs the cost of paying on time or before time.
HOW TO BOOST YOUR WORKING CAPITAL USING ACCOUNTS PAYABLE
Okay, now that we have grasped the fundamental knowledge of accounts payable and working capital, let us now discuss ways of using accounts payable to boost our working capital without necessarily threatening our credit rating or denting our relationship with our suppliers.
The conventional wisdom is to pay at the last day given to you by the supplier. This however is not the best strategy when your supplier gave a cash discount for early payment. Let’s use two simple examples to demonstrate this:
EXAMPLES OF PAYMENT ON THE FINAL DUE DAY
Example one; a supplier gave 3/10, net 30 discount term on a £100 bill. The annual interest cost is as follows:
(3 /97) x (365 /20) = 56.44%
Example two; a supplier gave 3/10, net 60 discount term on a £100 bill. The annual interest cost is as follows:
(3 /97) x (365 /50) = 22.58%
You can see from the above simple examples that the opportunity cost of not taking an early payment discount decreases as the net credit period increases. I have seen some businesses foregoing early cash discount in a short net credit period. That is financial management blunder in the highest order. The golden rule of using accounts payables as a source of financing is not to use it when the net credit period is short. You can negotiate for more days if you have influence.
I have to no doubt that you have at this point fully appreciates the importance and roles as vital component of working capital management that yields optimal result. This is to say that trade credit or accounts payable is a source of short-term finance that helps to keep the working capital low. As a manager or business owner, I urge you to start leveraging on the power of accounts payable to meet the short-term financial needs of your organization.