In the ordinary course of operations, a business sells products or provides services. In order to do this, the company must purchase supplies and materials from outside vendors. These vendors then send invoices to the purchasing company, thereby creating trade payables.
Trade payables can be simply defined as debts owed by a business to its suppliers or vendors.
Terms of Trade Payables
Most of the time, repayments of trade payables are due in 30 days. Occasionally, a vendor might offer 60- or 90-day terms depending on the type of industry.
Since suppliers like to receive their cash as soon as possible, they sometimes offer discounts for prompt payment. A common discount for paying early is the 2/10/30. Translated, this means that the customer would receive a 2 percent discount off the invoice amount if paid within 10 days. Otherwise, the full amount of the invoice is due in 30 days.
Unlike banks, vendors do not charge interest on outstanding invoices.
Accounts Payable Definition
The balance sheet of every business has a current liability designation for accounts payable. These are debts that are due within one year and are considered short-term liabilities.
Since trade payables are normally due within 30 days, they are posted in the A/P accounting portion of the balance sheet.
Trade payables are usually recorded as a separate line item in accounts payable. Other short-term payables could be accrued expenses, taxes payable or accrued wages.
Importance of Trade Payables
When a company first starts in business, it will need to fund its operations with some combination of capital and debt. Banks are typically reluctant to lend money to startups without a strong history of profitable operations. Even if a bank does offer a line of credit, they will want to collateralize their loans with liens on some of the company's assets and owners' personal guarantees.
Credit from suppliers is not as strict as a bank. Unlike banks, most trade payables are unsecured extensions of credits. Sometimes, in the case of a small, closely held business, a supplier may ask for the personal guarantees of the owners.
For these reasons, obtaining credit terms from suppliers is an important source of funding for startups and is a continuing ingredient in financing future growth.
Suppliers' Risk in Extending Credit
A vendor is willing to accept more credit risk than a bank for several reasons. First, the vendor will be selling materials or services that will have high gross-profit margins. Second, if the customer pays on time, the vendor will continue to sell materials and make additional gross profits.
For example, a distributor of ball bearings might have a gross profit margin in the range of 25 to 35 percent. Let's say the distributor sells $100,000 worth of ball bearings over one year and makes a gross profit of 30 percent, or $30,000. If the terms of payment are 30 days, the distributor's average outstanding receivable from the customer will be $8,333 ($100,000/12 months). With just a couple months of sales, the distributor has made enough profit to cover the loss of receivables if the customer suddenly failed to pay the outstanding amount. Banks don't have this luxury. They operate on thinner profit margins and must have more stringent protections for their loans.
Trade payables are an important source of financing for all businesses. On-time payments to suppliers get reported to credit bureaus, and a good credit rating gives a company access to other types of financing. In addition, suppliers are a good source of information for their customers by giving advice on how to more efficiently use their products and improve profits.