Accounts Payable | Days Payable Outstanding – Accounts Payable is money that needst o be paid to the Suppliers of raw materials, services to the company. This is one of the most simple and easily understood term under current liabilities section.

We note from above, Wal-Mart accounts payable has increased over the last 10 years, thereby resulting in Days Payable Outstanding increase from approximately 36 days in 2010 to 40 days in 2016. What does this mean? Is it good or bad for the company?

In this article, we will try to look at different aspects of accounts payable so that we can understand how account payable works in organization settings and why it is important.

• What is Accounts Payable?
• Days Payable Oustanding
• Interpretation of Accounts Payable
• Examples of Accounts Payable
  • Example#1 – Accounts Payable
  • Example#2 – Calculate Days Payable Oustanding
• Colgate Days Payable Oustanding Analysis
• Sector Days Payable Oustanding
  • #1 – Soft Drink Companies – Days Payable Oustanding
  • #2 – Oil & Gas Companies – Days Payable Oustanding
  • #3 – Energy Companies – Days Payable Oustanding
  • #4 – Airline Industry – Days Payable Oustanding
  • #5 – Discount Stores – Days Payable Oustanding
• Accounts Payable Process
• In the final analysis

What is Accounts Payable?

As the name suggests, accounts payable is the money that needs to be paid to the suppliers. Usually, it’s shown as a liability in the balance sheet as it is a liability for the business.

Let us take a basic example.

Let’s say Company A produces shoes for men and women. And Company B supplies leathers to Company A. Now, Company A took $40,000 worth of supply from Company B on a credit which needs to be paid within a month. In this case, to Company A, Company B is the creditor and the amount of accounts payable is $40,000.

If we look at this situation from a different angle, we will see that to Company B, Company A is the debtor and the amount, $40,000 is accounts receivable.

From Walmart 2016 filing, we note that accounts payable were $38,487 million in 2016 and 38,410 million in 2015.

source: Walmart 2016 10K Filings

As businesses are run on a large scale, not every purchase or sale can be in cash. So businessmen purchase or sell on credit to create more convenience for their partners in business. As a result, the concept of accounts payables and accounts receivables needs to be understood.

Under the accrual method of accounting, the receiver of goods or services on credit must report the liability immediately. Immediately means on the date when the goods or services were received.

Other than having accounting connotation, accounts payable is also considered as a process which reviews all account payables entries and whether they are rightly entered into the system or not.

Under accounts payable process, usually, the following information are reviewed –

• Invoices from company’s suppliers
• Purchase orders sent by the company
• Receiving reports sent by the company
• Contracts and other agreements

Days Payable Oustanding

Our understanding of accounts payable wouldn’t be complete until we know how the entire thing takes place. Let’s have a look.

The most important ratio in regards to accounts payable is Days Payable outstanding  (DPO) which means “how much time a company takes to pay off the due to its vendor”.

The entire process takes place as following.

First, the company sources raw materials/semi-finished goods/finished products from the vendors. But in order to keep the cash and manage the cash flow properly, the company goes in agreement with the vendors. The vendors usually let the company pay in 15, 30 or 45 days.

That means, if the company purchases the raw materials/semi-finished/ finished products from the vendors, the company is allowed a duration of time to pay off the due. It helps the company manage their cash flow better and also they don’t need to pay for the purchase in cash immediately. And that’s the reason – accounts payable is also called as a short term loan.

So, understanding Days Payable Outstanding is important.

Let’s have a look at the formula of Days Payable Outstanding –

Days Payable Outstanding (DPO) = (Accounts Payable / Purchases) X Number of Days in a year

• Ending Inventory = $500
• Beginning Inventory = $200
• Cost of Goods Sold = $500
• Accounts Payable = $200

In this example, we need to first find out Purchases during the year.

If you remember the BASE equation in accounting, we can easily find purchases.

• B + A = S + E
• B = Beginning Inventory
• A = Additions or Purchases during the year
• S = COGS
• E = Ending Inventory
• we get, A = S + E – B

Purchases or A = $500 + $500 – $200 = $800

With this we can find the Days Payable Outstanding.

Days Payable Oustanding = (200/800)*365 days = 91.25 days.

Some analysts take Number of days in a year as 360 days. Here we have used 365 days notation.

Interpretation of Accounts Payable

Let’s talk about why calculating accounts payable is important.

• First of all, as an investor, you are an outsider and you always don’t have a clue where the company stands. Irrespective of shiny financial statements, the actual position of the company hides which the investors need to discover. And that’s why days payable outstanding is so very important. By using the simple formula, the investor can find out after how many days the accounts payable was cleared. And if there is any delay, why.
• Second, depending on the payment schedule; vendors decide the merit of the company. If a company pays the payable amount within the mutually decided period (i.e. 15 days, 30 days or 45 days), then the vendors look at them as esteemed customers. Otherwise, the vendor may change the terms and conditions of the contracts. Investors, by calculating DPO, can understand why certain agreements have been changed.
• Thirdly, days payable outstanding helps the company strike a balance between paying too early and paying too late. Delaying the payment for few days will be helpful for a company who needs to make the payment to the vendors. Because delaying the payment will enable the company to hold more cash. However, waiting too long for making the payment can also be critical for the relationship between the company and the vendors; because vendors may not too much delay in making the payment.

Examples of Accounts Payable

First of all, it is important to know that accounts payable only exist in the case of accrual accounting. It doesn’t exist in cash accounting system.

So, let’s look at few examples through which we can understand the concept of accounts payable.

Example#1 – Accounts Payable

Mr A has sources raw materials from Mr B for producing leather jackets and selling it to the end customers. We could only find the following information –

Total Purchase – $39,000

Cash Purchase – $15,000

Mr B has mentioned that if Mr A paid the invoice within 30 days of the transaction, he will be entitled to get another 2% discount on the total purchase.

So, what’s the amount to be paid if the actual payment is done within 30 days?

It’s a simple example. We just need to follow a step-by-step approach to find out how much needs to be paid.

Total purchase is $39,000.

Cash purchase is done in cash i.e. $15,000.

That means credit purchase would be = ($39,000 – $15,000) = $24,000.

As it is mentioned that the amount for credit purchase (accounts payable) is paid within 30 days of stipulated time, it’s assumed that 2% of discount on total purchase is also received.

So, the actual payment that needs to be made is = ($24,000 – $39,000*2%) = $23,220.

Example#2 – Calculate Days Payable Oustanding

You are an investor and you need to know how a company is doing in term of its account payable process. So you decide to check through their financial statements. And here’s what you found –

In the Balance Sheet, you found the account payable which is $65,000.

Ending Inventory = $100,000

Beginning Inventory = $150,000

And through income statement, you found out the COGS i.e. $850,000.

Now it’s time that you find out for how many days, the accounts payable becomes outstanding.

Solution –

First we apply the BASE Equation to find the Purchases during this period.

A (purchases) = S (COGS) + E (ending inventory) – B (Beginning Inventory)

Purchases = $850,000 + 100,000 – 150,000

Purchases = $800,000

Now, let us apply the Days Payable Oustanding Formula

Days Payable Outstanding (DPO) = (Accounts Payable / Purchases) X Number of Days in a year

Putting the value in the formula, we get –

Days Payable Oustanding= (65,000/800,000) x 365

Days Payable Oustanding = $65,000 / $2328.77

Days Payable Oustanding = 29.65 days  (approx.)

Colgate Days Payable Oustanding Analysis

Below is the snapshot of Colgate’s Historical Balance Sheet from 2007 to 2015. If you want to learn Financial Statement Analysis in detail, you can have a look at this in-depth Colgate’s Ratio Analysis 

The first step is to find the Purchases. Purchases 2015 = COGS 2015 + Inventory 2015 – Inventory 2014

source: Colgate SEC Filings

Once we have the purchases, we can now find the payables turnover. Please note that we use the average accounts payable to calculate the ratio.

We note that Payable turnover has decreased to 5.50x in 2015. This implies that Colgate is taking a bit longer to make payment to its suppliers.

Sector Days Payable Oustanding

Now that we know what Accounts payable is along with how to calculate days payable outstanding, let us look at some of the sectors, top companies with their days payable outstanding.

We take the examples of Soft Drink Sector, Energy Sector, Oil & Gas Sector, Discount Stores and Airline Sector

• We note that Energy sector has higher days payable outstanding as compared to software companies. Most of the companies
• Most of the companies listed above have days payable outstanding of approximately 3 months
• NextEra Energy, however, has higher days payable outstanding of 267 days.

Accounts Payable Process

Account Payable Process is one of the most important business processes of any company. And in many cases, account payable process is being outsourced. So, what is Accounts Payable Process?

Here’s a brief overview.

Accounts Payable process is important since it includes almost all the payment beyond the payroll. This process is usually handled by a separate department in large organizations. But in the case of small firms, accounts payable process gets outsourced or handled by a book-keeper.

There are three things that are important in account payable process –

• The exact amount of quantity that the company has ordered (accuracy is the key).
• What the company has actually received from the vendors.
• Whether there is any issue in the calculation or not (for that account payable process examines the unit cost, terms & conditions, totals and any other calculations).

One thing that ensures the smooth running of accounts payable process is having an internal control.

Having an internal control is beneficial to a company for following reasons –

• It catches up any fraudulent attempt to extract more money from the company than due.
• It helps the company calculates the right amount to pay and not more or less.
• It detects the possibility of getting invoiced twice or more and helps curb any additional expenses.
• It also cross-checks the possibility of getting charged extra for the products that have been ordered.

That means, having your accounts payable process in place will help you curb the cost and excess payment; and will help you maintain enough free cash in the organization.

Other articles that you may like

• ROIC – Return on Invested Capital
• Equity Turnover Ratio
• Capital Gearing Ratio 
• Capitalization Ratio
• FIFO vs LIFO 

In the final analysis

Accounts Payable is an important concept in an organization if the organization follows an accrual method of accounting. In cash accounting, there is only cash inflow and cash outflow. Thus, there is no existence of accounts payable or accounts receivable.

As an investor, while understanding accounts payable, you also need to make sure that you cross-check all these amounts with the vendors’ statement (if you can get your hands on them). In addition to accounts payable, you need to perform a comprehensive Financial Statement Analysis of the company to get the full picture.

The post Accounts Payable | Days Payable Outstanding | Formula | appeared first on Free Investment Banking Tutorials | WallStreetMojo.