The Cash Cycle in Motion: Purchasing & Accounts Payable

Purchasing & Accounts Payable in Motion

In this course, we’re exploring the components of the cash cycle. In this lesson, we’re focusing on how purchasing drives accounts payable and how the management of accounts payable influences cash flow and cash balances.

Cash Cycle

The Components of the Cash Cycle

OPEN THE CASH CYCLE MODEL

The delay between receiving a bill for a purchase and paying that bill is measured in days payable. The longer the delay, the shorter your cash cycle – other factors held equal.

In our dynamic model, purchasing inventory and monthly operating costs drive the Receiving Bills inflow to Accounts Payable:

Receiving Bills

Purchases of inventory and recurring operating expenses drive the Receiving Bills inflow to the Accounts Payable stock.

The Paying Bills outflow, on the other hand, is determined by the payment terms negotiated with your employees, vendors, and suppliers and your payment policy. The shorter your Average Payment Cycle, the larger the outflow relative to Accounts Payable:

Payment Cycle

The shorter your payment cycle, the larger the Paying Bills outflow relative to the Accounts Payable stock.

If we let this scenario play forward with a 30-day payment cycle, the rate of receiving bills (given anticipated growth in inventory purchases and operating expenses) exceeds the rate at which bills are paid such that the Accounts Payable balance reaches $7,150 by the end of the 36-month forecast period:

30-day Payment Cycle

Accounts payable growth assuming a 30-day payment cycle.

If, for instance, you were to slow payment to 45 days, the accumulated Accounts Payable at the end of the forecast would grow to $10,600:

45-day Payment Cycle

Accounts payable accumulation assuming a 45-day payment cycle

Under the slow-pay scenario, you have the use of an extra $3,450 at the end of 36 months. In effect, you’ve shortened your cash cycle by extending your accounts payable (holding your purchasing and accounts receivable collection policies constant).

Real World Constraints

If you are Amazon, you can dictate favorable payment terms to your vendors. Your accounts payable can become an important source of financing for your business. If you are a human scale business, on the other hand, your capacity to stretch your accounts payable is constrained. Employees like to get paid monthly; the landlord likes her rent paid on time; and the taxman isn’t very forgiving about delayed tax payments. Extending your accounts payable might seem like a cheap and convenient way to shorten your cash cycle, but it is – at best – a short-term option for most of us.

Lesson tags: cash flow