What is Accounts Payable? A Guide to Understanding Your Business’s Financial Obligations

Featured Image

Source: Freepik

Accounts payable look simple–at least on paper. Invoices come in, and payments go out. It’s the typical repetitive back-office function that forms the backbone of your company’s finances. 

In reality, however, it’s so much more than just this. 

When you understand the significance of accounts payable and implement the best practices for optimizing the entire process, you can improve cash flow, free up resources, save time, enhance financial reporting accuracy, and more. 

In this article, we are getting into everything you need to know about accounts payable (plus seven expert tips to optimize the process for better efficiency). Let’s start with understanding: 

What is Accounts Payable?

Accounts payable, also known as AP, are your company’s short-term financial obligation or debt. They are represented as a short-term liability on your company’s balance sheet–the amount of money creditors expect from you in the near future. 

You can categorize business accounts payable into two types: Salaries and Expenses. Expense AP is the amount of money you owe your suppliers and vendors on credit for service or goods. They typically take the form of supplier invoices but can also include checks and bills. Salaries, on the other hand, include employee wages. 

Accounts payable examples include:

  • The cost of acquiring goods from suppliers for manufacturing or selling in your store
  • Utilities–electricity, water, internet and phone services, security, etc.
  • Salaries
  • Employee wages
  • Rent for the office space and property taxes
  • Transportation and logistics
  • Subcontracting work with another company or agency

Does Accounts Payable Matter?

Yes, they do. As mentioned before, while accounts payable may look like a routine financial obligation – which it is – managing it is a crucial aspect of your business operation and economic health. It directly impacts your:

Cash flow

Effective AP management is a non-negotiable part of maintaining a healthy cash flow. Timely invoice payments ensure you have sufficient funds to cover immediate and long-term expenses. 

However, a lack of it can lead to cash flow shortages, potential financial distress, and even missed opportunities for early payment discounts. 

Relationship with Vendors

Timely and accurate payments show that you are a reliable and professional business–thus fostering trust between the company and the suppliers. 

Strengthened vendor relationships can help you land better terms, potential future collaboration, and priority deliveries during shortages or overbookings.  

Financial Analysis and Reporting

The accounts payable ledger provides detailed insights into short-term liabilities and payment patterns. You can use the data to prepare your financial statements, forecast cash flow, and analyze vendor spending. 

Moreover, the reporting will help you oversee specific trends–like seasonal variations in expenses–thus empowering you to make informed financial decisions. 

Cost Control

Recording and analyzing accounts payable helps you avoid overpayments. With the correct data set, you can identify invoice errors and detect potential cost-saving opportunities. 

It also helps avoid duplicated or fraudulent payments, in turn protecting your company’s valuable resources. 

Financial Stability of Your Business. 

Every company must adhere to various legal requirements, industry-specific policies, and tax regulations. This often includes clearing payments within a given period to avoid penalties or legal consequences. 

However, you can stay on top of all deadlines with diligent AP optimization. Plus, you can also prevent fraudulent activity and enhance financial transparency. 

How Does Accounts Payable Work?

The accounting department of every business has set procedures before releasing payments to creditors. For the majority, the process looks like this: 

Invoice Generation

The accounts payable journey begins when you purchase inventory from suppliers on credit. This way, while you receive the product/service on the spot, the payments are processed after a certain agreed-upon period (mostly 30-60 days).

Then, the supplier issues the invoices and sends them via email, mail, or EDI (electronic data interchange).

Recording Accounts Payable

Next, your team records the invoices in the company’s accounting system and verifies that the received invoices are accurate and match the goods or services that were provided to you.

This is when you must cross-reference the invoice details with purchase orders, contracts, expenses’ legitimacy, and delivery receipts. Once verified, they are sent to the corresponding personnel–department heads or managers—for review and approval. 

Upon approval, you need to record the invoices as accounts payable, creating a liability on the company’s balance sheet. Like all financial transactions, they are recorded using a double-entry bookkeeping system, where a credit entry is made in an AP account, and a corresponding debit entry is made in an asset or expense account. 

Processing the Payment

Finally, you must pay the invoice. Businesses process payments through prearranged terms and methods with the vendors, including electronic fund transfers, digital payments, or checks.

Thus, your outstanding financial obligation (accounts payable) is fulfilled. 

Tips to Optimize the Accounts Payable Process

Now, with the basics out of the way, here are seven practical ways you can optimize accounts payable for your business to boost efficiency and accuracy:

Digitize Invoice Processing

Every business’s invoice processing function looks similar. It starts with the vendor sharing the invoice, followed by manual data entry in accounting software, approval, and payment. 

However, manually implementing these tasks takes up crucial time, demands more resources, and increases the chances of errors. The long wait can even jeopardize your vendor relationship and cash flow.

Fortunately, intelligent invoice processing solutions exist, and they are transforming how invoices are generated and paid. 

Using intelligent data extraction, automated invoice processing software automatically matches invoices against receipts, purchase orders, and approval workflow. Plus, it will help you avoid delays, errors, and late fees, maximizing visibility and improving accuracy. 

Leverage AP Automation

Automation is the way to go in 2024 and beyond for every department, and accounts payable are no different. A reliable accounts payable automation solution gives you the power to enjoy faster payment, boost efficiency, and maintain a healthy cash flow. 

Therefore, consider using accounts payable automation for every possible step of the process, like invoice capturing, data extraction, cross-checking and approval, and payment processing. Then, make sure you integrate the software with your existing accounting and ERP systems.

One task that accounts payable automation excels at is optimizing invoice approvals. You can base its workflow on predefined criteria and existing data, which will reduce the time it takes for payments to be issued.

Even better, encourage your vendors to switch to electronic invoices. This will further eliminate manual data entry and reduce errors from both sides. 

Learn to Prioritize

Not all invoices will weigh equally for your business. Of course, each genuine invoice should be paid in the most timely manner. Still, you can also significantly boost efficiency by organizing and prioritizing invoices–both in terms of time and money. 

Prioritize invoices that offer early payment so you can reap the benefits. In most other cases, hold off paying the invoices until a few days before the deadline to help better manage cash flow. 

However, make sure the payments do not arrive late to any supplier, as this can negatively affect vendor relationships. Always account for the time banks take to process and issue the transactions.

Set Up Payment Reminders 

When all your AP invoices are consistent and recurring, you rarely miss the payments. It’s when they break patterns that the chances of missing or forgetting the payment altogether could arise.

However, the solution is simple–automated payment reminders. Integrate the reminders with your account systems. This way, when an invoice is recorded, the automation will create a reminder before the due dates.

The automation is ideal for digital invoices that often come with reminders. However, it can also be easily integrated with the processing steps for offline invoices. 

Use KPIs to Measure Accounts Payable Efficiency

You can’t improve what you can’t measure. That’s why you should set specific goals and KPIs to measure how your business copes with the accounts payable optimization steps. 

Here are a few crucial AP metrics examples you can start assessing:

  • Cost of processing a single invoice (on average)
  • Average payment processing time
  • Rate of invoice paid on and before time
  • Days of Payable Outstanding (DPO)
  • Number of disputes or questions from vendors
  • Percent of early payment discounts and benefits captured

Give your optimization strategies time to decide if they were a success. Then, check the defined KPIs regularly and see how they are trending. Ensure the metrics consistently trend toward your goals.

Streamline your Managerial Workflow

The more complex your conventional AP systems, the higher the chances of late payments and errors. Therefore, create a detailed managerial workflow. The workflow will give you a worm-eye view of the operations in the accounts payable department.

Start by assessing your existing workflow and see the consistent hurdles in the approval process. Streamline the invoice approval process by standardizing and centralizing processes and reporting across the company.

This step is especially vital for companies with multiple locations and purchasing capabilities. It ensures that all processes and payments are cohesive and centralized.  

Establish Reliable Fraud Detection

There’s always the possibility of fraud when dealing with money. These frauds can come from different sources–cybercriminals, vendors, or even your own employees.

Fraudsters can use a plethora of scams to hack into your accounts, including mimicking email addresses from suppliers and asking the invoices to be paid to a different account. Scammy employers can also set up dummy supplier accounts to extract money.

Here, a reliable accounts payable automation solution can be a lifesaver. With a more rigorous approval tracking system and a clear audit trail, you can have real-time visibility of invoice status and catch discrepancies and outright errors. Flag those for further investigation. 

Supercharge Accounts Payable Processes 

Whether you are a small-to-medium enterprise (SME) or a multinational company, accounts payable reveal more than what you owe. They offer a clear picture of your financial commitment. More importantly, consistently tracking it gives you invaluable insights into your business’s financial operations and well-being. 

As your business grows and the financial complexities accompany it, ground yourself with the fundamentals. Understand accounts payable. Leverage automation to supercharge the different elements of your AP processes. Using the above-shared tips, optimize your business’s financial obligations to minimize the losses and maximize its growth potential. 

Receive afreecost analysis

In Touch
Sales Team
Online now
In touch
Call now