Accounts Payable is Not Long-Term Debt

This will be a very short article. It is a follow up to Current or Long-Term Debt that discussed the appropriate use of various kinds of debt.

Accounts Payable

A comment made in a forum about accounts payable is what prompted this brief update on debt and how it is used. The commenter noted that a company was reclassifying some of its accounts payable to a note payable. When I heard this all kinds of bells and whistles went off. This is usually an indication of existing or forthcoming financial problems.

Short-term Debt

In reality accounts payable is a form of short-term debt. But, it might be called a special form of short-term debt. For example, a line of credit is also short-term debt that is primarily intended for managing fluctuations in the business cycle. It is not intended to remain unpaid more than a year. A case in point might be a business that is highly seasonal. A line of credit may be used to meet some normal operating expenses during the slow part of the year and then be repaid during the time when sales are at their highest. Of course, the risk in this is that there is always the possibility that those higher sales never materialize. That is one reason a proven track record may be necessary to acquire a line of credit. When a line of credit goes beyond a year without being paid off completely it becomes what is known as an evergreen loan. It has become long-term debt which was never the intention. But, where does accounts payable fit in the equation?

More Immediate Needs

We use accounts payable to finance the purchase of things like inventory, office supplies, utilities, etc. In other words, they are either assets that will be (or at least should be) use in a month or two like inventory, or they are period expenses like supplies and utilities. This is used to fund the day-to-day operations of a business, and as such they are expected to be paid off usually within 10 to 60 days, depending on the suppliers’ terms.

Now the Danger

The case above where the company was going to reclassifying some of its accounts payable as a note payable raised concern because now the obligation would no longer be met during normal operating cycles of a month or two, but rather over a longer (perhaps much longer) period of time. But here is the problem. Let’s say a company purchases inventory to meet its needs for the next month. That means that the money collected from sales over the next month should be used to pay this accounts payable obligation when it is due in 30 to 45 days. This of course presumes that the company has some reserve funds in order to initiate paying on time. If not, then there may be a delay in paying. However, if accounts payable is reclassified to a note payable that means the company cannot pay in the normal time frame. If the note payable is a short-term one it still represents a departure from expectations when the purchase was made. If the note payable is long-term then the conclusion might rightfully be formed that the company is experiencing significant financial trouble, probably a cash flow one.

All of this supports the need to carefully manage inventory levels and to collect accounts receivable in a timely manner. For more on the importance of this see 3 Low Cost Sources of Cash – Part 1 and 3 Low Cost Sources of Cash – Part 2.

Is your company making appropriate use of accounts payable, a line of credit or other short-term debt, and long-term debt?

If you want to know more, contact AimCFO – Contact

As always, your comments are welcomed.

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