In last week’s post we talked about accounts receivable, other people owing you money. In today’s post we will discuss accounts payable, the money you owe others, and other forms of current liabilities. As we can tell from the most fundamental equation of a business, Assets = Liabilities + Equity, liabilities is a very crucial part that determines the success of a business. Current liabilities, with its critical influence of the cash flow of a company, even more so decides the “life and death” of a company’s operations.
The first kind of current liabilities is accounts payable. If you read my blog post last week, it means, quite intuitively, the credit you’ve paid but yet to put the cash in. It usually stands for a big percentage of the current liabilities. In 2007, Verizon reported 14,462 million dollars of total current liabilities, and 4,491 million of which were accounts payable, about 31% of the total amount.
We have two tools to analyze the significance of your accounts payable: accounts payable turnover (APT) and accounts payable days outstanding (APDO). Accounts payable turnover reflects the company’s success in using credit to finance purchases of goods and services. And it is computed as:
APT = Cost of goods sold/Average accounts payable
The company wants to use credit to make greatest possible purchases, so that there are plenty of cash flow for the company when it’s needed. In other words, the lower the APT the better. Low APT means high cash flow.
Accounts payable days outstanding reflects the quality of a company’s credit purchases. It is computed as:
APDO = Accounts payable/Average daily cost of goods sold
The company wants to extend the accounts payable due days as long as possible, so that it’s effect on the company’s cash flow in minimal. (On the premise that the extension doesn’t hurt the supply channel relations.) Therefore, the higher ADPO the more free cash flow the company possesses everyday, which is very beneficial.
Accrued liabilities is really similar to accounts payable. The only difference lies in that accrued liabilities are debts that aren’t yet billed, while accounts payable are debts that are billed. Contingent liabilities is a type of accrued liabilities with only an estimate value because the specific value of the debt is yet to be determined. For example, if a company faces a law suit, it has to report the law suit in its financial statements. However, the company does not yet know how much it will lose in the law suit, and can only report an estimated value of the loss. These kind of liabilities are therefore called contingent. Accrued liabilities in general require contains much more uncertainty in the numbers than accounts payable.
The last type of current liabilities is unearned revenue. It is also the most special kind because you don’t actually owe anybody any cash. You owe your customers product or service in unearned revenue. For example, if you are a magazine company and 1000 people paid for a whole-year subscription, you owe these 1000 customers all the magazines you will publish for the rest of the year. Even though you don’t really owe anybody cash, in the financial statements, unearned revenue is still reflected through monetary values. The monetary value is computed quite simply as the number of product or service owed multiplied by their retail prices.
That covers the three types of current liabilities. Current liabilities are often smaller in value compared to long-term debts. However, they are just as important, if nor more, because they are closely connected to the cash flow of a company.