Every business owner would like to have all sales on a cash basis, but that’s not always possible in a competitive marketplace. Sometimes, sellers need to offer sales on credit terms just to get customers to buy their products. Unfortunately, selling on delayed payment terms opens up an entirely new aspect of running a business: managing the extension of trade credit to customers. constitute a current or short term liability representing the buyer’s obligation to pay a certain amount on a date in the near future for value of goods or services received. They are short term deferments of cash payments that the buyer of goods and services is allowed by the seller. Payables is extended in connection with goods purchased for resale or for processing and resale, and hence excludes consumer credit provided to individuals for purchasing goods for ultimate use and installment credit provided for purchase of equipment for production purposes. Payables serve as non-interest bearing source of funds in most cases. They provide a spontaneous source of capital that flows in naturally in the course of business in keeping with established commercial practices or formal understandings.
Accounts payable and its management is a critical business process through which an entity manages its payable obligations effectively. Accounts payable is the amount owed by an entity to its vendors/suppliers for the goods and services received. To elaborate, once an entity orders goods and receives before making the payment for it, it should record a liability in its books of accounts based on the invoice amount. This short-term liability due to the suppliers, vendors, and others is called accounts payable. Once the payment is made to the vendor for the unpaid purchases, the corresponding amount is reduced from the accounts payable balance. On the other hand, when a company purchases goods on credit which needs to be paid back in a short period of time, it is known as Accounts Payable. It is treated as a liability and comes under the head ‘current liabilities’. Accounts Payable is a short-term debt payment which needs to be paid to avoid default.
Accounts Payable is a liability due to a particular creditor when it order goods or services without paying in cash up front, which means that you bought goods on credit. Accounts Payable as a term is not limited to companies. Even individuals like you and me have Accounts Payable. We consume electricity, telephone, broadband and cable TV network. The bills get generated towards the end of the month or a particular billing period. It means that the service provider gave you some service and sends the bill which needs to be paid by a certain date or else you will default. This becomes Accounts Payable.
Every entity will have an accounts payable department and its structure depends upon the size of the business. Accounts payable section is set up based on the probable number of vendors & service providers, the volume of the payments that would be processed for a period of time and the nature of reports that would be required by the management. For example, a small entity with less number of purchase transactions would require a basic accounts payable process. Whereas, accounts payable department of a medium/large enterprise will have a set of procedures to be followed before making the vendor payments. Set guidelines here are essential because of the value and volume of transactions during any period of time. The process involves:
- Receiving the Bill : In the case of goods, the bill/invoice helps in tracing the number/quantity of goods received. The time for which the bill is valid can also be known when the bill is received on time.
- Scrutinizing the Bill for Details : The vendor’s name, authorizations, date, and requirements raised with the vendor based on the purchase order can be verified too.
- Updating the Records for the Bills Received : Ledger accounts connected to the bills received need to be updated. Here, an expense entry is usually required to be made in the books of accounts. In cases when accounting software is used, recording some expenses may require managerial approval. The approval will be based on the bill value. As a precautionary step, large companies usually follow the ‘maker and checker’ concept for posting.
- Making Timely Payment : As and when the due dates arrive (based on a mutual understanding with the vendor/supplier/creditor), the payments need to be processed. Here, the required documents need to be prepared and verified. Details entered on the cheques, vendors bank account details, payment vouchers, the original bill, purchase order/agreement, etc., need to be scrutinized. Often the signature of the authorized person may be required. Once the payments are made, the vendors/suppliers/creditors ledger account has to be closed in the books of accounts. This will reduce the liability earlier created. In simpler words, the amount showed as payable, will no longer be seen as a liability.
The procedures mentioned above are organization specific. They can be stricter for large companies with more approvals required. However, the basic steps are needed to be considered before payments are made in order to avoid errors and frauds.
There are several advantages of trade payables. Some of them are as follows:
- Informality : In payables, there is no rigidity in the matter of repayment on scheduled dates; occasional delays are not frowned upon. It serves as an extendable, convenient source of unsecured credit.
- Increased Sales : A customer will buy more of a supplier’s products if they don’t have to pay cash immediately for their purchases. The most common credit term offered by sellers is payment within 30 days. Rarely do you see credit terms extended beyond this time.
- Customer Loyalty : The extension of credit terms tells the buyer that the seller considers them trustworthy and has confidence that they will pay their bills when they’re due. The buyer rewards the seller’s vote of confidence by continuing to make purchases.
- Continuous Financing : Even as the current dues are paid, fresh credit flows in, as further purchases are made. It is a continuous source of finance. With a steady credit term and the expectation of continuous circulation of payables-backing up repeat purchases, payables does in effect, operate as long term source.
- Easy to obtain : Payable is readily obtainable, in most cases, without extended procedural formalities. During periods of credit crunch or paucity of working capital, payables from large suppliers can be a boon to small buyers.
- Suppliers assume the risk : Where the suppliers have the advantage of high gross margins on their products, they would be able to assume greater risks and extend more liberal credit.
- Incentives for Customers to Pay : Even when they offer 30 days credit, sellers often encourage their customers to pay sooner by offering them a 2 percent discount if they pay with 10 days. The existence of this potential discount is a huge incentive for buyers to pay earlier. If a buyer does not take advantage of the 2 percent discount, this means that he’s paying a very high interest rate to delay payment for the additional 20 days.
- Competitive Advantage : A seller who is able to offer trade credit to buyers has an advantage over his competitors, if they are not able to offer credit terms. This makes sense. Naturally, a buyer would prefer to purchase on credit terms than to pay cash for all of his purchases.
There are several disadvantages of trade payables. Some of them are as follows:
- Accounts Receivable Monitoring : Businesses must offer some level of extended payments to be competitive in their markets. Extending credit terms to buyers is common in most industries. However, offering credit terms requires taking risks and spending additional time monitoring and collecting accounts receivable.
- Extending credit : Extending credit is creates more outstanding accounts receivable and someone needs to monitor these customers to make sure that they are paying on time. A company that is making its sales in cash does not have this problem.
- Accounts Receivable Financing : The extension of credit terms to buyer’s means that the seller has to finance these receivables. A seller may have to lean on his own suppliers to receive trade credit, borrow on his bank line of credit or use the company’s accumulated retained earnings. All of these methods have an inherent cost of capital.
- Negative Effect on Cash Flow : The most immediate effect of trade credit is that sellers do not receive cash immediately for sales. Sellers have their own bills to pay and extending credit terms to buyers creates a hole in their companies’ cash flow.
- Must Investigate Creditworthiness of Customers : Just like a bank, a vendor who extends credit to customers’ needs to analyze their credit ratings. This takes money and time. Obtaining business credit reports, such as Dun & Bradstreet, cost money, and making calls to check on references takes time. A vendor may need to hire an additional person who has credit analysis skills to help make the decisions about extending terms of payment.
- Possibility of Bad Debts : Inevitably, the extension of trade credit will lead to some buyers not paying their debts. When this happens, an employee needs to spend time making collection calls to the late payers, and, eventually, the seller may need to write off the unpaid receivables and take a loss.