When an item is purchased on credit, the seller will usually specify a period within which the payment should be made. The seller may also provide a discount if the buyer is willing to make an early payment. The terms of the trade credit will specify these details. For example, the terms “2/10, net 60” indicate that the buyer will get a 2% discount if he makes the payment within 10 days of purchase. If the buyer doesn’t want to make use of the discount period, then the payment will be due within 60 days. These credit terms differ across industries and also depend on competition, economic conditions, prevailing interest rates, etc.
Just like inventory and accounts receivables, it is important for a firm to manage its accounts payable effectively. If the accounts payable are paid too early, then it is unnecessarily using its cash, which could have been utilized elsewhere (opportunity cost). However, if it delays too much in making payments beyond payment due date, it may spoil its relationship with the suppliers, which will lead to stricter credit terms in the future. Some suppliers may also charge interest if payments are made beyond due dates.
In order to ensure that the company manages its accounts payables effectively, it needs to have a formal guideline or policy in place. Such a policy will address several factors that will help them streamline the processes and bring transparency to the whole system. Some of the factors are listed below:
- Whether payables are handled from a centralized location or decentralized.
- Details of the supply chain such as the number, size and location of vendors. For example, a company may restrict buying from vendors that are below a certain size, or it may want to buy only from local vendors.
- Details of the trade credit, and the alternative costs of borrowing.
- Details of inventory management system as they affect how fast payables can be processed.
- Adoption of commerce and electronic payments for improved efficiency.
An important tool used by companies to measure the effectiveness of payables management is the average days of payables outstanding. A short payables period indicates that the company is paying faster. It could be because the company is taking advantage of discounts available for paying early. A long payables period indicates that either the company is a dominant player and can afford to pay late and take advantage of the extra credit period, or it indicates poor payables management or liquidity problems within the company.
