Managing accounts payable or trade credit is crucial for a business from various angles. First of all, it satisfies the working capital financing needs of the business. Secondly, efficient management of trade credit leads to better profitability. Appropriate relationship management with the vendor strengthens the supply chain system of the organization, enabling them to achieve sustainable development. But before moving to the techniques to manage accounts payable, it is necessary to know what the need is for managing accounts payable.
Why Managing Accounts Payable is Important?
It is imperative to have a sound management policy to plan and control the accounts payable / trade credit for the following 3 reasons.
- Why Managing Accounts Payable is Important?
- Techniques to Manage Accounts Payables
- Ratios For Managing Accounts Payable/Trade Credit
Source of Working Capital Finance
Accounts payable are a vital source of working capital finance widely used by businesses. Therefore, proper management of accounts payable helps in determining the optimal level of working capital.
Impact on Profitability
Utilizing trade credit or bank finance for making payments to vendors is a decision directly impacting profitability. Since such options come with high-interest costs.
Management of accounts payable also helps in maintaining a healthy relationship with suppliers which is a must for a robust supply chain system.
Techniques to Manage Accounts Payables
After learning why managing accounts payable are necessary, it is crucial to learn how to manage the accounts payable effectively. The following techniques are employed by the manager for managing accounts payable or trade credit.
Negotiate Prices, Cash Discount, and Credit Period
It is pretty obvious that all three – price, discount, and credit period are vital. With lower prices and higher cash discounts, the better and more competitive will be the prices. A longer credit period will reduce the finance overhead of the company.
Calculate and Analyze the Cost of Trade Credit
The job of the accounts payable manager is not over after negotiation. Availing trade credit or discount or bank finance is also needed. For that, he should calculate the cost of trade credit and then compare it with other financing options, and then make the appropriate decision. If trade credit is utilized, having a higher cost in comparison to bank finance will diminish the profits and profitability of the business.
Strengthen Supplier Relationships
This function of an AP Manager looks a little contradictory in comparison to others, but it is of utmost importance. It is an accepted fact that one business is dependent on another business. The buyer of raw materials and other components is also dependent on the supplier. While managing and negotiating with suppliers, the manager should not try to take unreasonable benefits out of them. That will hamper the relationships, negatively impacting the supply chain and, hence, sustainable development.
Better Credit Terms
The company should negotiate longer credit periods with its vendors. Longer credit periods should not be at the cost of interest or any other charges. If a company is able to negotiate a credit period from vendors that is longer than the credit period it offers to its customers, it can significantly reduce the working capital requirements.
The company should build software that sends reminders to make the payment at the end of the credit period. The reminders should begin 7 days in advance so that it becomes easy to forecast requirements and plan cash flow for the payment.
Along with reminders, a company can also automate its payments with the help of integrating the accounting systems with bank accounts in such a way that it does not miss its payments.
Ratios For Managing Accounts Payable/Trade Credit
There are various ratios that can be pretty helpful for accounts payable managers to best perform their role. These ratios give a different and strategic insight apart from the normal benefits of the techniques listed above.
Accounts Payable to Total Current Assets Ratio
This ratio gives the extent of current assets financed by the accounts payable or trade credit. The lower this ratio, the higher the liquidity will be. It is somewhat reciprocal to the current ratio. While managing or stretching the trade credit, the liquidity position of a whole business should also be kept in mind.
Accounts Payable to Total Current Liability Ratio
This ratio indicates the dependence on trade credit as a means of financing. Please note that current liabilities here include short-term bank financing as well. A banker or potential investor may also infer that the business is facing difficulty in raising external financing and hints of some business problems.
Accounts Payable to Sales Ratio
With the help of this ratio, two firms of similar nature or two different periods of the same firm can be compared. That would indicate the extent of trade credit utilized by the business to generate sales.
Change in Accounts Payable to Change in Sales Ratio
This is indeed a crucial one. This indicates the correlation between sales and trade credit. In general, an increase in sales will increase the levels of accounts payable as well. It is important to see an increase in sales by 1%, increasing the accounts payable by how much percentage. To manage accounts payable effectively, the accounts payable manager should try to keep this ratio on the lower side, i.e., below 1.