What are Trade Payables? Benefits and Risks

“In a world awash in debt, power shifts to creditors.” 

 

- Fareed Zakaria

 

What is Trade Payable?

 

Trade Payable is a sum that company owes to its vendors, third parties or suppliers. Company has to purchase raw materials and then deliver finished goods to its customers. In this whole process, the company purchases supplies and the payment is either done in cash or credit. 

 

Cash payments are usually avoided if the amount is heavy. All the credit purchases are included in Trade payables. In simple terms, every credit purchase of the company is included in Trade Payables. But there is a time-based difference that classifies trade payables into long term and short term. 

 

If the credit period is 12 months or less then we include it in Current Liability else Non-Current Liability. Trade payables are important to be accounted for in the books because they help us understand the cost incurred in doing business. 

 

Trade Payables are a mix of Trade Creditors and Bills Payables. Now, let us understand both of these.

 

• Trade Creditors

 

Trade Creditor is just another name given to Trade Payables. It includes suppliers, vendors or any other third party to whom the company owes money.

 

• Bills Payable

 

Bills Payable include the money that we borrow from the bank for a short term. Later on we owe this money to the bank. There are often mixed views on whether Bills payable is a part of Trade Creditor or Accounts Payable. 

 

In the UK, Bills Payable is used to denote Accounts Payable. But it is still a part of Current Liability and can be included in Trade Payables. These payables can include phone bills, utility bills or any petty bills too.

 

We need to understand the fact that not every person to whom we owe money is termed as Trade Payable. There are certain exceptions to it as well. 

 

Like the employees salary and wages is not a part of Trade Payable irrespective of the fact that the company owes money to them. Salaries and wages are operating expenses for the company. 

 

Likewise, dividends, employee costs, recreational costs etc are not a part of Trade Payables. It depends on company to company and industry to industry that costs are included in Payables. 

 

But there are some standard examples like-

 

1. For cafes- Ingredients purchased on credit are a part of Trade Payables.

 

2. For the Clothing industry- Material and items purchased through retailers on credit are a part of Trade Payables.

 

3. Manufacturing Industry- Items/ Raw Materials on credit are a part of Trade Payables.

 

4. For Bars/Pubs-  Bottles of alcohol bought on credit are a part of Trade Payables.

 

 

Difference Between Trade Payables and Accounts Payable

 

Trade Payables and Accounts Payable terms are used interchangeably. They are the same but there is a minute difference between both these terms based on the situations. 

 

Trade payable is used to refer to the money that a company owes to its vendors for purchasing either inventory or inventory related goods. It may be raw materials, supplies or any other thing. 

 

Whereas, Accounts payable can be used to express any short term obligation or debt of a company. Be it inventory related or not, we include it in accounts payable. So, Accounts Payable is a wider concept and Trade Payables are a part of it.

 

Here is an example to explain that explains the difference between both. Suppose a restaurant bought some supplies from a food industry on credit. The money that it owes to the food industry will be a part of Trade Payable. Reason being, it is inventory for the restaurant. 

 

Whereas, other obligations of the restaurant like paying the dues to the cleaning company for cleaning the uniforms of the staff, maintaining the gardens on a regular basis etc will be a part of Accounts Payable. Reason- they are not the part of inventory but still an obligation to be settled on a monthly basis.

 

Together all such short term obligations will also become a part of Accounts Payable. There are many companies that treat Trade payable as Accounts payable, since the latter is a broader concept. But it depends from company to company which head they prefer to use.

 

Also Read | Accounts Receivables 

 

Benefits of Trade Payables

 

There are 2 ways of payment to vendors- Cash payment and credit payment. Which method will be more suitable depends upon: Size of the order, Amount involved, Relationship with the Vendor, Discounts, Capacity of the Entity etc. 

 

Many times companies prefer the Credit option. Some of the reasons why people prefer Trade Payables over Cash Payment are :
 

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Reasons why Companies choose Trade Payables

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1. More Cash Flow

 

If companies use Trade Payables method as a way to purchase inventory and inventory related items then it means it can maintain its cash flow for a specific period of time i.e until the liability to pay off the creditors arises. 

 

In case of financial difficulties companies can use this cash to settle salaries and wages of employees and other operating expenses. Company can also save itself from taking a bank loan or any debt. Therefore, one of the reasons why companies prefer trade payables is because they help to maintain cash flows.

 

2. Better Relationships

 

It is a known fact that in every business certain relationships are formed while dealing with outside parties. Such as a relationship between a supplier or a vendor with the company. 

 

The vendor supplies raw materials to the companies and in return companies pay them. Trust is very important in such business relationships. 

 

Companies need raw materials and if they are approaching the same vendor every time and paying his dues timely a strong trustworthy relationship is built. Moreover, vendors might offer discounts and reduced prices if the connection is worth it. 

 

Therefore, another reason why companies prefer trade payables is because they can maintain better connections with the vendors.

 

 

3. Short Term Liquidity

 

Short term liquidity means the ability of the firm to convert its assets into cash or cash equivalents in the quickest time possible. When trade payables increase the cash balance of the company also increases. 

 

It may be temporary but there is an increase in the cash which increases the short term liquidity of the company. Therefore, one of the reasons for preferring credit over cash payment is to maintain the short term liquidity.

 

Possible Risks When Dealing with Trade Payables

 

There are lots of incidents where people act selfishly for their own gain and the ultimate result is a big fraud in the company. How are these frauds related to Trade Payables? What are the potential risks that we need to look out for when dealing with Trade Payables? 

 

Given below are some of the possible risks faced with Trade Payables that you need to mitigate to avoid any kind of losses in the firm.

 

1. Frauds

 

Frauds can be classified into 2 types based on their happening i.e. External frauds and Internal frauds. In case of External frauds, the whole process of trade payable accounting can be exploited by Collusion or by kickbacks (also called Overpayments). 

 

Collusion means involvement of an internal employee with an external vendor to carry out fraud or misrepresentation. Kickbacks on the other hand means overpayment for an invoice for personal gains.

 

As per ACFE, a business suffers at least 5% losses due to frauds. Internal frauds in case of trade payables are more dangerous as an employee can intentionally hamper the accounts of vendors for his/her personal gains. 

 

Dummy vendor accounts can be created to show payments. The ultimate aim is to send money to your own account by routing it through a fake vendor account. 

 

Therefore, external and internal frauds risks are always prevailing when you deal with Trade Payable accounts.

 

 

2. Conflicting Interest

 

It is also a potential risk when you deal with Trade payables. Sometimes companies set loose controls or limited supervision over the vendor invoices or trade payable accounts. Because of this vulnerability employees can exploit the opportunity. 

 

Therefore to remove such conflicting interests proper labor division, surprise checks, continuous monitoring should be done. Companies should check who is getting the money at last and who is paying it. 

 

Conflicting interests not only occur because of loose controls but also when businessmen start receiving gifts or unnatural favors from outside. 

 

Healthy practice would be to maintain a professional relationship with the vendor and not accept any kind of gestures beyond work.

 

 

3. Undue Payments

 

Doing late payments or missing the deadline of payments sounds so normal. Company professionals are engaged in so much work that it is normal to have late or missing payments to vendors. 

 

But have you ever wondered if it is because of lack of operational management? Yes, sometimes the invoice processing or maintenance process can be slow or it may not run as efficiently as you might think. It will cause disruption and ultimately lead to delays. 

 

These delays will reflect while payment. Because of which you may have to pay penalties, interests or fines. Since nowadays companies have IT systems and centralized databases, everything is integrated and interconnected. 

 

Delay in one ledger can cause delay in every other process. Therefore, missing payments and delay in payments to Trade payables can be another potential risk. 

 

 

4. Lack of Clarity

 

Another potential risk while dealing with Trade payables is lack of clarity. Sometimes businesses lack the basic knowledge of purchasing and choosing the right vendor. 

 

Sometimes they do not record the right journal entries of purchase into books. Lack of accuracy while recording and processing transactions can lead to errors while matching later on. 

 

Omissions in entries, wrong figures, improper adjustments are all due to lack of clarity and knowledge. These mistakes are very difficult to pinpoint because no one has time to recheck everything from the start. Therefore, another potential risk to mitigate when dealing with Trade Payables is to get conceptual and practical clarity.

 

Also Read | Business Process Management

 

Trade payables are liabilities for a company. They are shown in the liability side of the balance sheet under current liabilities. But these are also beneficial for multiple reasons that we have discussed above.