A company will have a hard time scaling if all of its cash is tied up in inventory. The solution is to buy on credit, but a bank loan comes with steep interest rates that eat into profits. Instead, many businesses establish credit with a supplier.
The record of what that company owes its supplier is called trade payables.
Trade payables is not just an accounting term. Armed with modern accounting software, a skilled finance professional can wield trade payables to secure adequate cash flow, build strong vendor relationships, and set a company on a smarter path to growth.
What Are Trade Payables?
Trade payables are short-term expenses incurred by businesses when they use products or services from a third-party vendor or supplier to deliver their products to their customer. Inventory paid for in cash is not documented in your financial statements as a trade payable.
Trade payables are tracked on a company’s balance sheet. Look on the right-hand side for liabilities, then scan down to find current liabilities. Under current liabilities, you will find accounts payable. This is the section where trade payables are recorded.
Finance professionals put trade payables under current liabilities on the balance sheet because they are typically paid to the vendor within one year. The specific cadence varies based on the agreement between the company and the supplier.
Some retail goods with high inventory turnover, like soap, may be paid off monthly. Slower moving or more expensive products, like vehicles, might be on an annual schedule.
The Difference Between Trade Payables and Accounts Payable
Trade payables are one kind of accounts payable. However, accounts payable are payments you owe for any goods or services provided by a vendor. Vendors would have a matching amount on their balance sheets under trade receivables and accounts receivable.
Examples of Trade Payables vs. Accounts Payable
Consider a restaurant. The raw materials like food, napkins, and to-go cups the restaurant purchases are all inventory that they then assemble and sell to patrons. Those are all trade payables. Meanwhile, the janitor who deep cleans the kitchen or the point-of-sale system the restaurant purchased are services, not inventory. Therefore, the money owed to those vendors, or trade creditors, is under the wider umbrella of accounts payable.
Other examples of trade payables might be the procurement of crude oil a refinery purchases to make asphalt, the T-shirts bought by a clothing retailer, or the bottle of whiskey ordered by the local bar.
The Benefits and Risks of Using Trade Payables
When used responsibly, the benefits of trade payables tend to outweigh the risks. Companies can also lean on technology to mitigate the risks and accentuate the benefits.
In general, the advantage of trade payables is the same for businesses as it is for using a personal credit card: a higher cash balance on hand and access to better deals.
Cash Flow and Liquidity
Trade payables and cash flow have an inverse relationship. As trade payables increase, the company is left with more cash on hand. As those trade payables are paid down, the company has less cash, or cash equivalents, to spend in other areas of the business.
Without trade payables, a company would need cash on hand every time it purchased from its suppliers. That means, raising more working capital or turning to a bank. Trade payables lets a company set up a system where it can pay its suppliers with the gross profits it earned from the inventory the supplier provided.
For example, let’s say a company agrees to buy $100 worth of chocolate bars from a supplier at $1 a piece. The company sells its inventory at $2 a piece over the next two weeks. The company pays its supplier back, and now it has $100 in cash flow to cover other expenses like marketing and salaries.
As a company builds a reputation for paying its trade payables in full and on time, they gain the trust of trade creditors. That trust leads to many positive outcomes.
First, it’s less likely for a supplier to end the relationship outright. In some industries like plastics, there are many suppliers, so it might not be such a big deal to lose a supplier. But, if a company is sourcing semiconductor chips or some other specialty item, it’s even more important to stay in the supplier’s good graces.
A good relationship can lead to prioritized deliveries in the case of supply chain snarls. The challenges of global distribution since March 2020 have laid bare the competitive advantage of being first in line for limited supplies.
A company might also receive more favorable payment terms like a discount or a longer payment window. For example, if the same chocolate company from before could extend its payment due date to every two months instead of every month, it would double the cash flow.
One way to show a trade creditor you’re a good partner is to have a good creditors turnover ratio. This figure shows how often you pay a trade creditor in a given time period.
The formula is Creditors Turnover Ratio = (Total Credit Purchases – Purchase Returns)/((Beginning Trade Accounts Payable + Ending Trade Accounts Payable)/ 2)
For example, a company makes $100,000 in credit purchases for the year from their trade creditor. Of those, $10,000 were returned for various reasons. The company’s trade payables account with the supplier stood at $15,000 in January and ended at $25,000 in December.
So, ($100,000-$10,000)/(($15,000+$25,000)/2) = 4.5.
That means the company paid their supplier 4.5 times during the year. If they are on a quarterly payment plan with their supplier, this shows they are making consistent payments. If a creditor turnover ratio is strangely low, it may indicate the company has cash flow challenges. This can make a supplier leery of partnering with the company.
The disadvantages of using trade payables primarily have to do with the challenge of tracking what the company owes to whom, as it scales.
Missed payments on short-term obligations are probably the biggest factor in strained relationships between trade creditors and buyers.
While this can happen intentionally, companies can also accidentally miss payments if they don’t have a good accounts payable system in place. The more cumbersome the invoice system is, the longer it takes to send and receive the appropriate paperwork. Invoices can get lost in the daily shuffle of paperwork, too.
A 2022 survey of 230 finance professionals revealed that 84% of industry insiders believed fraud has increased since 2021. That report primarily focused on external attacks like ransomware or phishing scams.
However, 46% of respondents said they also worried about internal fraud. Bad actors can create fake vendors and route money through those accounts into their personal accounts. Or they can overcharge for a delivery from a real supplier and take a cut.
Disreputable suppliers can also charge for inventory they never delivered.
The best way to fight these kinds of fraud is to have a sophisticated, organized accounts payable team backed by software that can automate invoices, conduct compliance checks, and use machine learning to identify patterns that suggest fraud.
Technology Is Modernizing the Trade Payables Workflow
The right software can maximize the benefits and minimize the risks of using trade payables as part of your cash flow management strategy.
Tipalti uses automation and machine learning to make managing the deluge of invoices simpler, while reducing errors and missed payments. Learn how Tipalti can help your accounts payable team handle their trade payables workflow more smoothly by booking a demo today.