Understanding the Impact of Accounts Payable on Free Cash Flow

Navigating the complexities of financial statements can often feel daunting, especially when it comes to understanding how changes in different accounts affect a company’s cash flow. One area that frequently raises questions is accounts payable (AP) and its relationship with free cash flow. Let’s delve into this topic and clarify how fluctuations in AP can generate additional cash flow.

The Dynamics of Working Capital Accounts

Before we focus on accounts payable, it’s essential to review the interplay among various working capital accounts: inventory, accounts receivable (AR), accounts payable (AP), and accrued liabilities (AL).

Inventory:

• Decrease: A reduction in inventory indicates that products have been sold. Although it changes the gross revenue down to net income, it does not represent a cash loss, necessitating its addition back into cash flow calculations.
• Increase: An increase in inventory reflects cash outflow to stock up on products, thereby reducing the available cash.

Accounts Receivable (AR):

• Increase: When AR rises, it signifies that revenue has been recognized, but payment has not yet been received. This necessitates a subtraction from cash flow, as it reveals that cash has not yet come in.
• Decrease: Conversely, a decline in AR implies that previously owed cash has been collected, increasing cash flow.

Accrued Liabilities (AL):

• Increase: An increase suggests that expenses have accumulated without immediate payment, leading to a cash flow addition since no cash has yet left the business.
• Decrease: A reduction indicates that expenses have been settled, resulting in a cash outflow.

Accounts Payable (AP):

Now, let’s address accounts payable specifically.

• Decrease: A decline in AP signifies that the company has made payments on its debts, leading to a cash outflow as obligations are settled.
• Increase: An increase in AP means the company has not paid for certain expenses yet, which translates to an immediate benefit to cash flow. This is because while the expense may have been recorded on the income statement, the actual cash has not been spent yet, allowing it to be viewed as available cash.

Analyzing the Increase in Accounts Payable

The key confusion often arises from how AP interacts with the income statement. When AP increases, it indicates that the company is leveraging credit and deferring payment on current obligations. Although expenses associated with these liabilities may impact