3 tips for successful Accounts Payable Management
Accounts Payable management is a Treasury process that actually originates in the Purchasing department. AP management incudes everything from selecting the best supplier to managing credit terms. A successful AP management system allows the company to have surplus funds and enables it to undertake short-term to long-term investments. This helps the company earn interest income.
Tip #1: Utilize the maximum credit term available by your supplier. The terms are usually given by the supplier and take into consideration the company’s creditworthiness and financial position. When applying for credit terms, always place your best foot forward by giving the most relevant reports and requirements to secure the best credit terms.
Tip #2: Use your ERP’s credit terms and credit limit functions to avoid unnecessary charges. Nowadays, ERPs include a feature to monitor credit terms & limits per supplier. This will help you in two ways; first, you will be able to manage your cash outflows better by avoiding unnecessary charges and second, it helps you maximize your bank account’s Average Daily Balance (ADB). This in turn will give you good financial returns.
Tip #3: Evaluate your payables management through metrics and short-term financial ratios. Accounts payable is one of the three main components of working capital. The other two are receivables and inventory.
It is important to understand how these three accounts interact with each other. It is also important to study the resulting effects of this interaction on working capital levels, cash flow, and the operating cycle. This can help to optimize management and evaluation of payables.
Of course, an appropriate balance must be struck. Due to this, the advantage of deferring cash outlays using trade credit is weighted against the risk of excessive short-term credit.
It is therefore important to maintain optimal utilization of credit lines and timing of payments. One has to create a balance between the need for cash, working capital, and liquidity.
Other Important Financial Ratios and Metrics:
Payables Turnover Ratio: Management can use this ratio to measure the average number of times a company pays its suppliers in a particular period. A higher number than the industry average indicates that the company pays its suppliers at a faster rate than its competitors. This is generally conducive to short-term liquidity.
Days in Payables Outstanding (DPO): This measures the average length of time it takes a company to pay for its short-term purchases in a particular period. The DPO can be used by management to determine the most favorable timing of payments for short term purchases.
Cash Conversion Cycle (CCC): This represents the length of time required to turn inventory purchases into sales, and subsequently, into cash receipts. Using the CCC, management can assess the interaction of payables with the two other working capital accounts; receivables and inventory. This allows for correct analysis of the resulting effects on cash flow. A low CCC is highly desirable. A company can shorten the CCC (for example), by lengthening its terms of purchases.
Net Working Capital (NWC): NWC is the difference between current assets and current liabilities. High levels are desirable for short-term liquidity. A decreasing pattern or trend in NWC can be attributed to increasing levels of payables. This can thus serve as a warning sign potentially reflecting excessive short-term credit. A negative NWC (particularly when persistent) is a red flag for lack of liquidity or a potential insolvency.
Current and Quick Ratios: The current ratio expresses the NWC equation as a ratio between current assets and current liabilities. The quick ratio indicates a company’s capacity to pay its current liabilities without needing to sell its inventory or get additional financing. Holding all else equal, rising A/P levels will reduce both the current and quick ratios. These ratios can be used to assess the impact of increasing payables on short-term liquidity.