Every company that purchases on credit has an accounts payable account. The size of the account is determined by the type of business and the company's cash management policies. While companies may have varying levels of accounts payable, large increases in the amount of payables can signal that a business is moving toward financial instability.
The Statement of Cash Flows
The statement of cash flows is one of the three main financial statements prepared by a company for external reporting purposes. The SCF shows changes in the balance sheet for the period covered by the income statement. It reconciles the opening cash balance for the year to the closing one. Each group of assets and liabilities and cash inflows and outflows that affect those accounts is detailed in the SCF.
Changes to Accounts Payable
Accounts payable is one of the accounts shown in the SCF. A decrease to the accounts payable account indicates a net cash outflow for the year because more accounts were paid than were increased. Alternatively, an increase in the accounts payable indicates a net cash increase because extra cash was available that did not pay down payables. Although the SCF shows the net activity in the accounts payable account over the year, it does not speak to the reasons behind the change. The two most common reasons for increases in the accounts payable balance during the year are a cash flow crunch and unchecked growth.
Cash Flow Crunch
One common reason for an increase in accounts payable is that the business is experiencing a cash flow shortage. The company tries to conserve cash by allowing its payables to build up. This is an important issue to identify quickly as it can be a leading indicator of illiquidity or even bankruptcy of the company. Increases in accounts payable that don't have a corresponding increase in sales are often accompanied by aging of the average accounts payable. For example, if a company once paid all of its payables within 15 days of receiving the invoice but now pays on average within 45 days, it may mean the company doesn't have enough money to pay all of its payables on time.
Another reason for increases in accounts payable balances is rampant growth in the company. This is also a critical trend to identify early as companies that grow without planning often bankrupt themselves. For example, a company that manufactures shoes may have to purchase raw materials more than 60 days before completion of the shoe. It may take another 45 days to ship the product to retailers and receive payment for it. In a growing company, payments for raw materials and labor will increase and have to be paid prior to receiving the increased revenue, causing a major cash shortage. If payables for raw materials or products are not paid on time, credit can be cut off and the company can find itself without a supplier.