Techniques of Managing Accounts Payable / Trade Credit

Managing accounts payable or trade credit is crucial for a business from various angles. First, it satisfies the working capital financing needs of the business. Secondly, efficient management of trade credit leads to better profitability. Appropriate relationship management strengthens the supply chain system of the organization enabling them to achieve sustainable development.

It is imperative to have sound management policy to plan and control the accounts payable / trade credit for following 3 reasons.

Techniques of Managing Accounts Payable Trade CreditReason 1:
Accounts payable are an important source of working capital finance widely used by businesses of all levels.
Reason 2:
Utilizing trade credit or bank finance is a decision having a direct impact on profitability.
Reason 3:
Healthy supplier’s relationships are the must for strong supply chain system.

How to manage the accounts payable effectively? Following techniques are employed by the manager for managing accounts payable or trade credit.

Negotiate Prices, Cash Discount and Credit Period: It is quite obvious that all three – price, discount and credit period are vital. Lower the price and higher the cash discount, better and competitive will be the finished goods of the buyer. Longer the credit period will reduce the finance overhead of the company.

Calculate the Cost of Trade Credit and Analyze the Benefits: The job of accounts payable manager is not over after negotiation. Analyzing trade credit should be availed or discount should be taken or bank finance to be availed is needed. For that he should calculate the cost of trade credit and compare it with other financing options and then take the appropriate decision. If trade credit is utilized, having a higher cost of funds in comparison to bank finance, it will diminish the profits and profitability of the business.

Strengthen Supplier Relationships: This function of an AP Manager looks little contradictory to the first two but it is of utmost importance. It is an accepted fact that one business is dependent on other business. The buyer of raw materials and other components is also dependent on the supplier. While managing and negotiating with suppliers, the manager should not try to take unreasonable benefits out of them. That will hamper the relationships which will have a bad impact on supply chain and hence on sustainable development also.

Ratios For Managing Accounts Payable / Trade Credit 

There are various ratios which can be quite helpful for accounts payable manager to best perform his role. These ratios give a different and strategic insight apart from normal benefits or losses listed above.

  1. Accounts Payable to Total Current Assets Ratio: This ratio gives the extent of current assets financed by the accounts payable or trade credit. Lower this ratio, higher will be the liquidity. It is somewhat reciprocal to current ratio. While managing or stretching the trade credit, the liquidity position of a whole business should also be kept in mind.
  2. Accounts Payable to Total Current Liability Ratio: This ratio indicates the dependence on trade credit as a financing means. Please note that current liability here includes the short-term bank financing as well. A banker or potential investor may also infer that the business is facing difficulty in raising external financing and smell some problem in the business.
  3. Accounts Payable to Sales Ratio: With the help of this ratio, two firms of similar nature or two different periods of the same firm can be compared. That would indicate the extent of trade credit utilized by the business to generate sales.
  4. Change in Accounts Payable to Change in Sales Ratio: This is indeed a crucial one. This indicates the correlations between sales and trade credit. In general, an increase in sales will increase the levels of accounts payable as well. Important is to see, increase in sales by 1% is increasing the accounts payable by how much percentage. Accounts payable manager should try to keep this ratio on the lower side i.e. below 1 for effective management of accounts payable.
Last updated on : August 31st, 2017
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