The relationship between accounts payable and cash flow

The average daily purchases on account is computed by dividing your total purchases on account by 360:

Using the accounts payable balance and your total purchases on account amount from the prior year is usually accurate enough for analyzing and managing your cash flow. However, if more recent information is available, such as the previous month's accounts payable information, then use it instead.

Be sure to compute the average daily purchases on account correctly using the number of days actually reflected in the purchases on account figure. For example, use 30 if one month's accounts payable information is used.

Case study: Average payable period

The average payable period gauges the relationship between your use of trade credit and your cash flow. The following example looks at how the average payable period is calculated.

Scott Widget, the owner and president of Widget Manufacturing, just received the quarterly financial statements from his accountant. The balance sheet shows that the ending balance in accounts payable was $9,424 for the quarter. The income statement listed $14,108 in manufacturing costs, and $8,212 in other operating expenses. Scott has decided to compute Widget's average payable period for the quarter.

Computing the average daily purchases on account

The average daily purchases on account is computed as Widget's total purchases on account divided by 90, the number of days in a quarter. For all practical purposes, Widget seldom pays cash for any manufacturing supplies or operating expenses. Widget has established credit with all of its suppliers and receives a bill for any purchases made over a certain period of time.

Therefore, Scott has determined that it is safe to assume that all of the manufacturing and operating expenses paid during the quarter were purchases on account. The total purchases on account is $22,320, which is the sum of the manufacturing costs ($14,108) and operating expenses ($8,212). Widget's average daily purchases on account is $248:

Computing the average payable period

The average payable period for Widget Manufacturing is 38 days:

During Widget's previous quarter, it used each dollar of its trade credit 38 days on the average. Each day that Widget Manufacturing can extend its average payable period delays $248 of cash outflow. You could also say that each day in the average payable period provides Widget Manufacturing with free financing.

Using the average payable period to manage cash flow

The average payable period can be used to see the benefits of the basic rule regarding cash outflows: Pay your bills on time, but never pay your bills before they are due.

The following chart illustrates the benefits of this basic rule.

*POA = purchases on account

The benefits of extending your average payable period should be crystal clear. For example, assume that your average daily purchases on account is $300 a day, and that your average payable period is 20 days. If you were able to extend your average payable period from 20 days to 30 days, adding those 10 extra days defers $3,000 in cash outflows. This also represents $3,000 of interest-free financing that you can use for reducing debt, or making other necessary purchases.

Accounts payable aging schedule

Using an accounts payable aging schedule can help you determine how well you are (or aren't) paying your accounts payable. If the schedule indicates that you have some bills that are past due, you may be relying a little too heavily on your trade credit. It could also indicate that you aren't managing your cash flow the way a successful business should.

An accounts payable aging report looks almost like an accounts receivable aging schedule. However, instead of showing the amounts your customers owe you, the payables aging schedule is used for listing the amounts you owe your various suppliers — a breakdown by supplier of the total amount of your accounts payable balance. Most businesses prepare an accounts payable aging schedule at the end of each month.

A typical accounts payable aging schedule consists of 6 columns:

1. Column 1 lists the name of each your suppliers with an outstanding bill.
2. Column 2 lists the total amount you owe to each of the suppliers.
3. Column 3 is the current column. Listed in this column are the amounts you owe to your suppliers for purchases made during the current month. Amounts listed in this column aren't past due yet.
4. Column 4 lists the amounts you owe that are 1 to 30 days past due.
5. Column 5 lists the amounts you owe that are 31 to 60 days past due.
6. Column 6 lists the amounts you owe that are over 60 days past due.

The number of columns can be adjusted to meet your reporting needs. For instance, you might prefer listing the outstanding amounts in 15 day intervals rather than 30 day intervals.

The following is a sample accounts payable aging schedule from Fortmann's Hawkeye Haven:

The accounts payable aging schedule is a useful tool for analyzing the makeup of your accounts payable balance. Looking at the schedule allows you to spot problems in the management of payables early enough to protect your business from any major trade credit problems. For example, if Jansa Distributing was an important supplier for Fortmann's, then the past due amounts listed for Jansa Distributing should be paid in order to protect the trade credit established with this supplier.

The schedule can also be used to help manage and improve your business's cash flow, especially when projecting your cash outflows for a cash flow budget. Amounts listed in the current column will need paying sometime in the near future — possibly 30 or 60 days.

Work smart

Check to see if your accounting software prepares the aging schedule automatically. Most will prepare an accounts payable aging schedule in a few clicks.

The accounts payable aging schedule gives you a good indication of the amount of cash needed to cover your expenses during the same time period. Using the example schedule above, Fortmann's Hawkeye Haven will need to generate at least $7,750 in income to cover the current month's purchases on account.