Spontaneous liabilities arise from the normal course of business. For example, when a retailer orders goods for inventory, the manufacturer of those goods usually does not demand immediate payment but instead extends a short-term loan to the retailer that appears on the retailer’s balance sheet under accounts payable. The more goods the retailer orders, the greater will be the accounts payable balance. Also in response to increasing sales, the firm’s accruals increase as wages and taxes rise because of greater labor requirements and the increased taxes on the firm’s increased earnings. There is normally no explicit cost attached to either of these current liabilities, although they do have certain implicit costs. In addition, both are forms of unsecured short-term financing, short-term financing obtained without pledging specific assets as collateral. The firm should take advantage of these “interest-free” sources of unsecured short-term financing whenever possible.
Financing that arises from the normal course of business; the two major short-term sources of such liabilities are accounts payable and accruals.
unsecured short-term financing
Short-term financing obtained without pledging specific assets as collateral.
Accounts payable are the major source of unsecured short-term financing for business firms. They result from transactions in which merchandise is purchased but no formal note is signed to show the purchaser’s liability to the seller. The purchaser in effect agrees to pay the supplier the amount required in accordance with credit terms normally stated on the supplier’s invoice. The discussion of accounts payable here is presented from the viewpoint of the purchaser.
The average payment period is the final component of the cash conversion cycle introduced in Chapter 15. The average payment period has two parts: (1) the time from the purchase of raw materials until the firm mails the payment and (2) payment float time (the time it takes after the firm mails its payment until the supplier has withdrawn spendable funds from the firm’s account). In Chapter 15, we discussed issues related to payment float time. Here we discuss the firm’s management of the time that elapses between its purchase of raw materials and its mailing payment to the supplier. This activity is accounts payable management.
accounts payable management
Management by the firm of the time that elapses between its purchase of raw materials and its mailing payment to the supplier.
When the seller of goods charges no interest and offers no discount to the buyer for early payment, the buyer’s goal is to pay as slowly as possible without damaging its credit rating. In other words, accounts should be paid on the last day possible, given the supplier’s stated credit terms. For example, if the terms are net 30, the account should be paid 30 days from the beginning of the credit period, which is typically either the date of invoice or the end of the month (EOM) in which the purchase was made. This timing allows for the maximum use of an interest-free loan from the supplier and will not damage the firm’s credit rating (because the account is paid within the stated credit terms). In addition, some firms offer an explicit or implicit “grace period” that extends a few days beyond the stated payment date; if taking advantage of that grace period does no harm to the buyer’s relationship with the seller, the buyer will typically take advantage of the grace period.