What is Accounts Payable?
Accounts payable (A/P) are amounts owed to suppliers and other creditors for goods and services bought on credit.
How Does Accounts Payable Work?
Let's assume that Company XYZ orders $1,000,000 in widget parts from its supplier and has 60 days to pay for those parts. Once Company XYZ places its order and/or receives the parts, it will increase its inventory account by $1,000,000 and increase its accounts payable by $1,000,000. When 60 days has passed and Company XYZ pays the invoice, it will reduce cash by $1,000,000 and reduce its accounts payable by $1,000,000.
When accounts payable go down, this is considered a use of cash on the company's cash flow statement, and as such, it reduces the company's working capital (defined as current assets minus current liabilities). When accounts payable goes up, this is considered a source of cash on the company's cash flow statement because the company is "stretching out" the time it takes to pay its invoices and thus not using cash as quickly.
Why Does Accounts Payable Matter?
Accounts payable is an important factor in a company's working capital. If it's too high, the company may soon be struggling to find the cash to pay the bills; if it's too low, the company may be unwisely directing its cash toward paying the bills too soon rather than enjoying the full grace period and investing that cash in the business instead. The level of accounts payable also affects several important financial-performance measures, including working capital, days payable, the current ratio, and others.
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