What Is Accounts Payable? How to Calculate AP Turnover

Accounts payable (AP) is the total amount of money a company owes to vendors for supplies or services provided to run their business. These payables are like a short-term IOU—a signed debt acknowledgment document—with mutually agreed upon payment terms. AP is a form of short-term debt which must be paid for within a year using its current assets—any resource or goods the company uses to generate cash flow, including cash on hand or other liquid assets. The accounts payable department may also be responsible for reimbursing expense account charges and managing petty cash for business purchases.

The accrual accounting system, the most common accounting method for businesses, categorizes accounts payable as a liability account in the company’s balance sheet, one of several critical financial statements reported by a business.

Careful bookkeeping of accounts payable enables a firm to monitor its cash flow accurately and ensure it meets its invoice due dates, thereby avoiding late payments and maintaining positive business-vendor relationships. A firm that defaults on its payments risks converting the current liability, or short-term debt, into bad debt that can adversely affect its liquidity.

Timely and accurate fulfillment of accounts payable is important because it affects a company’s cash flow, credit terms, ability to attract investors, and provides useful information about its overall financial health. Investors and lenders also use these metrics to assess a firm’s liquidity and business management practices when determining whether to invest or loan money.

Working capital, for example, is one of the key liquidity metrics impacted by accounts payable. Working capital is the amount of money a business has on hand to cover its immediate, day-to-day costs. It is calculated by using a business’s current assets and current liabilities. Ideally, a business’s inflow should exceed its outflow, guaranteeing it has enough working capital to cover its costs. Thus, poorly managed accounts payable can jeopardize a company’s ability to stay in business.

The accounts payable process is a cycle that involves invoicing, logging, and payments:

• The firm creates a purchase order. The accounts payable cycle begins once the firm creates a purchase order for the goods or services, like raw materials and office supplies, provided by an outside vendor. The purchase order (PO) acts as a contract between the firm and the vendor, featuring details about the purchase, including describing the goods or services rendered, the fulfillment date, and the price.
• The firm receives and reviews the delivery. Upon receiving the delivery, the firm will create a receiving report to confirm the receipt of the goods or services and verify their condition and quality. The department will then ensure that the goods or services align with the PO and note any issues on the receiving report.
• The vendor issues an invoice. Once the firm approves the goods, the vendor will issue an invoice.
• The AP department logs the invoice. Upon receiving the invoice, the accounts payable (AP) department will make an entry in its general ledger, crediting the account payable account for the amount owed. Due to the impact accounts payable has on a company’s relationships and overall profitability, it is vital for business owners to establish rigorous and efficient AP processes and internal controls to prevent fraud and overpayments.
  
• The AP department processes the invoices. Once the invoice is paid, the department will debit the account. Firms can process the invoices using accounting software or automated invoice processing. Larger firms use automating invoice processing to streamline the bookkeeping process, thereby ensuring their financial records are up-to-date and their obligations are met. Large companies may have enough resources to dedicate an entire payables department to stay on top of invoice processing and payments. Still, small businesses can use accounting software for AP automation.

Accounts payable and accounts receivable are two distinct types of accounting systems. Accounts payable refers to the amount of money that a company owes a vendor for services or products it has supplied and is considered a current liability account, which is a debt that the firm must pay within the fiscal year.

In contrast, accounts receivable refers to money that customers owe from previous purchases and is considered a current asset. The sum of these asset and liability accounts ultimately impacts the profit reported in the firm’s income statement.

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