Friday, March 15, 2013

Teaching Note on Accounts Payable Management

The very idea of ‘accounts payable’ depends on the ‘(business is a) going concern’ concept of accounting. Accounts payable are the amounts due to suppliers of goods and services that have not yet been paid. These are important short term sources of finance, they are usually referred as ‘spontaneous’ or ‘self adjusting’ sources of finance. As long as business remains as a going concern, volume of accounts payable depends on the level of firm’s operations. Accounts payable policy of a firm also depends on accounts receivable policy of the supplier. In other words accounts payable are the other side of the account receivables’ coin. Accounts payable predominantly include trade credit and accrual expenses.
Trade credit
Trade credit refers to credit that a buyer firm gets from the suppliers of goods in the normal course of its operations. It is a dominant part of accounts payable. It appears as ‘sundry creditors’ on the Indian firms’ balance sheets. Trade credit is a cheaper source of short term finance than the institutional agencies. It is because suppliers, having better information and control over buyer than the institutional agencies offer better terms in extending the trade credit.
The advantages of trade credit are as follows:

·         Easy availability: In most of the cases (except financially distressed firms), trade credit is automatic and does not require any negotiations.
·         Flexibility: As mentioned earlier, the amount of trade credit is positively associated with the level of firm’s operations. It increases (decreases) with the increase (decline) in firm’s sales.
·         Informality: Trade credit is a spontaneous source of finance, does not require any formal agreement.

Trade credit seems to be cost free as it does not involve any explicit interest charges. But it involves implicit cost. Extending trade credit is nothing but financing buyer purchases; it involves costs to the supplier. Such costs of trade credit may be transferred to the buyer firm by increased price of goods / services. However, the extent of such a transfer depends on the bargaining power of supplier and buyer in the market.

Accrual expenses
            Accrual expenses represent the liability that a firm has to pay for the services, which it has received. They include accrued wages, salaries, taxes and interest payments, etc.

Managing Accounts Payable
            Terms of the trade credit usually includes cash discounts, say ‘2/10, net 30’. It implies that 2% discount if paid within 10 days (or) full payment by the end of the credit period i.e., 30 days. Here the buyer firm’s financial manager has to take the policy decision whether to avail the cash discount or not. If the financial manager takes the discount, it benefits the firm in terms of less cash outflow, but the firm foregoes the credit granted by the supplier beyond the discount period. If the manager does not take discount, he avails credit for the extended period but pays more. It means buyer firm incurs opportunity costs when it does not avail cash discount.
The cost of credit (implicit cost) during the discount period is zero. It will be beneficial for the firm to pay at the end of the discount period. Once the discount period ends the cost of credit suits up and declines as the credit period ends. For example, if the terms are ‘2/10, net 30’. The cost of trade credit is 73.47% if the credit is paid on the 20th day. It will be 36.74% if it is paid on the last day of the credit period i.e. 30th day. So the firm will be advantageous to pay the credit on the last day of the credit period, if it does not avail the cash discount. However, the financial manager’s decision of availing cash discount depends on his firm’s cost of short-term borrowing. If the buyer firm’s cost of short term borrowing is greater than the minimum cost of credit on any day during the credit period, the firm should not avail the cash discount and make the payment on the day when cost of trade credit is minimum (i.e., on the last day of the credit period).

Stretching accounts payable
            It refers to the delaying of payment beyond the due date. Such a delay minimizes the net present value (NPV) of accounts payable disbursement. That is, longer the time for payment, lower is the NPV of payment disbursement and higher the value of the firm. It incentivizes the financial managers to stretch the accounts payable and avail the increase in positive float. Though stretching accounts payable benefits firm, it also imposes costs on the firm. These are penalty for delayed payment and other indirect costs. Indirect costs include erosion of goodwill, poor credit rating and declining credit availability. NPV of accounts payable disbursement depends on firm’s opportunity cost of capital, time delayed, and penalty for delayed payment.
            Where V = value of the order; Penalty = delayed payment calculated on Rs 1; t_s= number of days payment is stretched; and K= daily opportunity cost of the firm on Rs 1.
            Financial manager of the buyer firm is incentivized to stretch the payment disbursement as long as possible without hurting the firm’s interests. Though arithmetic calculation doesn’t consider indirect costs, they are important for the firm’s long term future. Hence, the financial manager is expected to make calculated move to increase the value of firm by appropriately stretching the accounts payable disbursement.

Evaluating Accounts Payable Management
Number of days payable is a useful measure for evaluating firms’ accounts payable management policies. The mere number of days payable will not help in making relative comments over the firm’s policy. Ideally, firm’s number of days payable is compared to its industry peer. The firm with more number of days payable is referred as having better credit terms. However, considering the other credit terms under which the credit is extended to the firm is very important. Larger number of days payable can also be conceived negatively about the firm’s financial health.

Note: The discussion would be effective in the class, if one includes the small cases at various stages of this lecture. For the appropriate case problems, please write to me, i am happy to share!
Hrishikesh Bhattacharya (2001), “Working Capital Management: Strategies and Techniques”, Prentice-Hall of India Private Limited, New Delhi.
Pandey I M (2003), “Financial Management” Vikas Publishing House Pvt Ltd, New Delhi.
Edgar A Norton, Jr., Kenneth L. Parkinson, and Pamela Peterson Drake (2011), “Working Capital Management” in CFA program curriculum -2011, Pearson Learning Solutions.