Managing Accounts Payable Managing accounts payable involves negotiating the terms of purchases, as

Managing Accounts Payable Managing accounts payable involves negotiating the terms of purchases, as

well as deciding when to pay amounts due. Remember that accounts pay- able are the “flip side” of accounts receivable—your accounts payable are someone else’s accounts receivable. Your suppliers are trying to minimize their costs, in terms of funds tied up in accounts receivable and bad debts. Yet, at the same time they are extending credit to generate more sales.

1 We did not start graphing the effective cost in Exhibit 21.5 until 18 days from the sale because the effective interest cost is extraordinarily high for days 16 and 17.

EAR paying 16 days after the sale = (1.0101) 365 − 1 = 3,817% EAR paying 17 days after the sale = (1.0101) 182.5 − 1 = 526%

Management of Short-Term Financing

Firms try to set these policies with an eye on the policies of their competitors, so terms of credit are uniform within industries. However, if your firm is an important customer of a particular supplier, you may

be able to negotiate better terms of credit. In calculating the cost of trade credit, managers know:

■ If you pay within the discount period you are using free credit—you can delay payment by, say, ten days and pay the same as if you paid in cash on the date of purchase.

■ If you pay beyond the discount period, the later you pay, the lower the cost of credit.

While paying beyond the due date does reduce the cost of trade credit even further, some other issues arise. First, paying taxes, insur- ance, or license fees late may cost you dearly in legal costs and sanc- tions. Second, your creditors may impose penalties for payments beyond the due date. Third, if you consistently pay late, you may damage your relationship with a creditor. Also, paying beyond the due date may hurt your credit rating, making it more difficult or more expensive to borrow funds from banks or to purchase goods on credit in the future.

Aside from the legal costs and the indirect and direct costs of paying late, there is an important ethical issue: You agree to specific terms when you purchase the goods on credit. Intentionally (or even uninten- tionally) violating these terms is unethical business behavior.

It is important to monitor accounts payable to ensure that discounts are taken when possible and payments are made within the specified period. You can evaluate your accounts payable management by exam- ining the accounts payable turnover, a measure of how many times within a specific period the accounts payable are created and paid:

credit purchases Accounts payable turnover = --------------------------------------------

(21-5) accounts payable

The numerator is the total credit purchases made in the period. The denominator is a typical accounts payable balance over this period. The larger the turnover, the faster you are paying your accounts. For exam- ple, if you have $2,000,000 of credit purchases in a year and your end- ing balance in accounts payable (using the ending balance as typical accounts payable) is $200,000, the turnover is 10 times:

$2,000,000 Accounts payable turnover = ------------------------------ =

10 times

MANAGING WORKING CAPITAL

A high turnover may be good news or bad news: good news since you are probably establishing goodwill with your suppliers by paying quickly; bad news if you are not taking discounts but paying your bills before they are due. A low turnover may be good news, since you are stretching your payments out, lowering the effective cost of trade credit; bad news if you are paying beyond the due date, which may harm your credit standing.

Deciding whether a specific accounts payable turnover ratio is good news or bad news requires a bit more information. You can learn more about our payable management by calculating how long, on average, it takes us to pay. If you know the accounts payable you generate on a typical day and your typical balance of accounts payable, you can calcu- late the number of days’ worth of payables you have in accounts pay- able. The number of days in accounts payable is calculated as:

accounts payable No. of days in accounts payable = ----------------------------------------------------------------------------- (21-6)

average daily credit purchases If total credit purchases for the year are $2,000,000, your average

daily credit sales are $2,000,000/365 = $5,479. This implies that the number of days in your accounts payable balance is $200,000/$5,479 per day 36.5 days. This tells us that it takes, on average, 36.5 days to pay your accounts. Is this good or bad? It depends on your credit terms. If your credit terms all have net days of 30, then having 36.5 days in your ending balance tells you that you are, on average, paying late. If your credit terms all have net days of 60, then having 36.5 days tells you that you are, on average, paying too early.

If the credit terms you face are varied, it is difficult to evaluate the number of days in accounts payable. A more detailed breakdown of accounts payable is necessary. One breakdown is to classify it into three groups:

■ Payables that are still within the discount period ■ Payables that are beyond the discount period, yet are not overdue ■ Payables that are overdue

Once you have this classification, you can focus on why each of the accounts payable is not paid when due and why discounts were not taken. This also allows you to plan for discounts that can be taken in the near future.

Another classification scheme is to “age” the accounts payable; that is, classify the accounts by the number of days since the purchase. This

Management of Short-Term Financing

breakdown allows you to identify the older accounts payable, as well as to plan ahead for the ones that must soon be paid.

Accounts payable management is a balancing act: The cost of trade credit must be balanced against the cost of alternative sources of financ- ing. For example, if bank loans cost effectively 10% per year, should the firm borrow from the bank or use trade credit with terms of 1/15, net 30? Answer: the bank, since it costs less (10% versus 27.706%). But many times, especially for small businesses, bank loans may not be available and trade credit is the only source of financing the purchases.

Bank Financing Banks lend money to firms under different financing arrangements. The

financing arrangement may be straightforward, such as a single payment loan. Or a firm may obtain from a bank its promise to lend, such as a line of credit or revolving credit.