Liabilities constitute a company’s legal obligations that occur during the course of its business operations. Liabilities appear on a company’s balance sheet, and they are classified as current or long-term. Two common liabilities listed on an organization’s balance sheet include accounts payable and notes payable. Accounts payable is classified as a current liability, and notes payable is classified as a current or long-term liability. A company must understand the importance of accounts payable and notes payable to effectively manage its finances.
Understanding Accounts Payable
Accounts payable represents the amount of money a company owes to its supplier for the purchase of goods or services on credit. The accounts payable account is listed as a current liability because a company must pay its debt in a short period of time. Most companies require business customers to pay their invoices within 30 days and do not require interest payments. Some companies analyze how effectively they pay their accounts payable balances by computing the accounts payable turnover ratio. To calculate the ratio, you must divide total supplier purchases by the average accounts payable for the period. Investors and managers use this information to calculate the number of times a company pays its accounts payable balance in a given period.
Understanding Notes Payable
Notes payable represents a written promissory note that a company receives when it borrows money from a lender. The notes payable account possesses a credit balance. For example, a company borrows $50,000 from a bank. The company posts a credit to its notes payable account for $50,000 and a debit to its cash account for $50,000. If a company must repay a note within one year, it lists the note on its balance sheet as a current liability. If the note is due in one year or later, the company lists the note as a long-term liability.
Interest on Notes Payable
In most cases, companies must pay interest on money borrowed from a lender. The promissory note states the specific interest rate and the terms. Common interest terms require companies to pay interest every six months. A company must account for interest paid on its notes owed to the lender. It must also accrue outstanding interest payments that it has yet to pay, which is typically done on December 31 of the initial year. When a company accrues interest, it debits interest expense and credits interest payable. When a company makes a payment on the principal balance and interest, it debits notes payable, interest expense and interest payable and credits cash.
The Balance Sheet
Accounts payable and notes payable are listed on a company’s balance sheet as a part of its liabilities. The balance sheet provides a snapshot of a company’s financial position at a given point. Managers and investors use the balance sheet to make important financial decisions regarding a company. Accounts payable and notes payable are used in conjunction with other accounts on financial statements to compute important financial ratios.
