Working Capital: payables

Accounts payable

Accounts payable, or simply payables, are the trade credit that is extended to a company by its suppliers.  Payables are liabilities, things the company owes to others.  In almost all instances payables are current liabilities, and, as such, part of working capital.  There are rare instances, however, where they are long-term liabilities.  I gave an example of oilfield service company behavior after the mid-Eighties collapse in energy prices in my post on receivables.  The corresponding item to the long-term receivables on the oilfield service balance sheet would be the long-term payables on its customers’.

Two ratios

There are two payables ratios of primary interest to a securities analyst:  payables/sales and payables/receivables.  Both are calculated using the payables and receivables figures taken from the balance sheet of a certain date.  The sales figure used is for the twelve months ending on the balance sheet date.

The ratios are compared, first and foremost, with a company’s own history.  But since a supplier normally provides customers with more or less standard raw materials on more or less standard payment terms, it is also reasonable to compare the payables to sales ratios among different firms in a given industry.  The results will give a first approximation for the relative market strength and relative bargaining power of industry participants.

1.  receivables/payables. Receivables/payables is a way of quantifying the relative strength of a company vs. suppliers and customers in the universe it operates in. In a CEO’s ideal world, customers would be so eager for the company’s products that they would pay in cash–or even in advance (therefore, no receivables)–and suppliers vying for the privilege of supplying the company would provide unusually long payment terms (big payables).  In CEO hell, on the other hand, suppliers would be so worried about the financial viability of the company that they would demand payment up front (therefore, no payables) and customers would take the finished product only if they could obtain (a la Chrysler) unusually generous financing (big receivables).

As a general rule, the bigger the number, the weaker the position of the company in question.  It’s also important to examine the historical record.  Is this ratio constant over time, or has it recently begun to signal strength or weakness?

Look at the raw numbers, too

In addition to looking at the ratio, you should look at the raw numbers as well–and in two ways.  First, consider how much of the overall credit extended to customers by a company is in effect being financed by credit it is receiving from suppliers.  Then look at the increase in receivables over the previous, say, three years and compare that with the increase in payables.  Do the competitive dynamics of the company’s industry allow the company to keep any of the benefit of increased credit from suppliers?  or has the company been forced to simply pass this financing benefit on to customers?

2.  payables/sales Decline in this ratio can be a very important early warning sign of impending trouble for a company.  Suppliers are constantly analyzing the prospects of all their customers.  Because they deal with a wide variety of firms in their targeted industries, and because they see the pattern of their customers’ payments for supplies, they possess a very sophisticated picture of the industry and each company’s place in it.

Trade creditors are also at the bottom of the pile when it comes to recovery during liquidation.  So they have a lot to lose if they continue to send materials to a failing customer.  As a result, shrinkage in payables is a very reliable indicator of potential trouble.

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