FollowAlthough accounting and finance come with a plethora of challenging ideas, there are certain concepts that most entrepreneurs are well aware of. For instance, it would be virtually impossible to find a businessman or woman that has not heard of taxes. Similarly, most professionals have had some experience with accounts payable.
In simple terms, this is an account that companies must keep when buying things now but choosing the pay later on. That way, their account with the seller will be deemed on-credit and must be paid within a certain, predetermined period of time. So, how exactly did accounts payable come around and what are the perks or downsides of relying on this method of payment?
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Benefits of Buying on Credit
When businesses start operating, they often have to face a lot of expenditures related to the set-up costs. This is why even the IRS allows those who qualify to deduct these costs over a period of five years. Even then, there is a big problem in the area of liquidity. For example, when someone has to pay a high business expense before bringing in the necessary revenues to cover that purchase, they will not have the cash to actually buy anything.
So, sellers often let them buy what they need immediately under the agreement where the money will be given to them relatively quickly. This is how accounts payable originally came to exist as companies simply did not have the necessary resources to cover the materials, fees, and other expenses related to the early stages of business.
Technical Aspects and Accounting
As far as the technical aspects of accounting, accounts payable are relatively easy to maintain. The normal balance of the account is credit and it is reduced every time that someone pays off what they owe. So, the necessary adjusting entry when someone pays off a part of their balance will be a debit entry. Additionally, accounts payable is a balance sheet account that does not affect the company’s income statement at all. It does, however, go into a lot of important calculations such as the liquidity ratio. Also, according to Forbes, there are many ways to optimize this account in order to make one’s venture smoother.
Potential Shortcomings
Obviously, there could be quite a few downsides of accounts payable. The most obvious one is the fact that companies could fall into a financial rut by relying on them too much. Consider, for instance, a business that brings in $10,000 in gross receipts a month. If their accounts receivable is too high when compared to that $10,000, they may never be able to pay it off. Of course, certain businesses can get away with higher payable balances due to their nature. The rule of thumb, however, is to keep them as low as possible as any deviation from that concept diminishes one’s ability to stay profitable for a long time.
Given all of the aforementioned, it is fair to conclude that accounts payable is one of the most popular terms in the spheres of accounting. Additionally, it is relatively easy to navigate even for those who may not have an extensive amount of technical knowledge. Regardless, companies should not over-use it as doing so could make it hard for them to repay the debt and lead to an unnecessary amount of interest costs.
