Throughout your business’s lifespan, you may take on debt to accomplish your goals.
Two common types of debt that businesses often encounter are notes payable and accounts payable. But despite having very similar names, they vary greatly in what they are and how companies use them to accomplish their goals.
To help you establish best practices for notes payable and accounts payable, we’ll define them, break down the differences, and provide actionable tips to optimize your debt management.
What are notes payable?
Notes payables are debts associated with financing from banks, individuals, or other financial institutions. They may be considered a long-term liability (if paid outside of 12 months) or a short-term liability (if paid within 12 months).
Outlined in notes payable are the borrowed amount, interest rate, and payment schedule the business must adhere to. The full amount to be paid, broken up into the principal and interest amounts, is explicitly communicated (typically on an amortization schedule).
Any debts categorized as notes payable are often accompanied by a promissory note. The promissory note is the written agreement with the terms and conditions of the debt clearly defined.
What are accounts payable?
Accounts payable are the outstanding invoices or purchases made on credit owed to vendors and suppliers.
If at the time of purchase, you receive an invoice with the goods or services rendered before payment, that purchase is categorized as accounts payable.
For example, if you hire a cleaning company to do a deep cleaning of the office and you receive an invoice on March 1st with a payment due date of March 31st, that is counted as accounts payable.
Accounts payable are short-term liabilities meaning they must be paid back within a year of the debt being accrued. Depending on the policy of the vendor or supplier, there may be interest or penalties for late payments which would be clearly outlined in the invoice or purchase agreement.
Notes payable vs accounts payable: key differences
While both are debts on the balance sheet, notes payable and accounts payable are managed and treated in very different ways. Here’s how they differ.
What is being obtained
Notes payable are associated with financing, like obtaining a loan. Businesses agree to pay back the amount with interest over some time (typically longer than a year) while adhering to a payment schedule.
Accounts payable are associated with goods and services. Businesses have obtained a good or service with an agreement to pay for it sometime in the future.
Interest accrual
Long-term financing debts like loans have interest that accrues over time. Each payment has some portion that pays down the principal balance with the rest paying down an interest amount—this is outlined in a payment schedule or amortization schedule.
Interest will only accrue on an accounts payable balance if a payment is late.
Even then, the interest that accrues on accounts payable depends on the terms of your vendor or supplier. The payment policy used may include an interest amount or a flat late fee for any overdue payments.
Payment terms
The payment terms for notes payable are more complex than the payment terms for accounts payable.
The payment terms for accounts payable include an amount, due date, and any fees or interest for late payments. Occasionally, there will be a payment schedule if the balance is to be paid down in installments.
Notes payable payment terms have more detail that outlines payment amounts, payment dates, interest, and sometimes collateral.
There’s more leeway in the payment terms of your accounts payable. If you have a good relationship with the vendor or supplier, they may be willing to accommodate a late payment without penalty.
Depending on the financing, you likely won’t get the same treatment with your notes payable. Banks and financial institutions fund their operations with the interest earned off their loans and will typically charge a fee for early payments.
Consequences of notes payable default
A business defaults on a debt if it fails to make repayments on schedule. The consequences of notes payable default are outlined in the promissory note or other documentation.
In some cases, defaulting on the debt will trigger a repossession or pursuance of collateral. This is when the financial institution takes a physical asset like equipment, vehicles, or real estate instead of missed payments.
The consequences of defaulting on an account's payable amount are less severe. The vendor or supplier may charge interest or late fees and break the working relationship, perhaps even refusing to deliver the goods or services purchased.
In either case, debt payments should be budgeted and planned for to minimize the risk of damage to the business’s finances or reputation.
Notes payable vs accounts payable example
A clothing company is about to place its first inventory order. The supplier has agreed to provide everything ordered for $20,000 which can be paid in two installments of $10,000 each at 30 and 60 days following the invoice.
However, if they are 15 days late on either payment, they will pay a 20% interest penalty. This means the business would pay an additional $2,000 in interest on one $10,000 payment.
The clothing company is now weighing two options to pay for the order.
They could pay the supplier in the two installments that they outlined in the payment terms. If they were to accept the terms, the debt would be recorded as accounts payable.
The other option is to take out a $20,000 loan at 5% interest paid over a five-year period, which would be notes payable.
Using an amortization calculator, they find that their monthly payment would be $377.42 with a total interest amount paid of $2,645.48.
If they choose to take the accounts payable option:
- The debt is short-term and must be paid back within two months
- Risking a late payment could cost the business an additional $2,000 and potentially losing their supplier
- Payment amounts are large, disrupt cash flow, and are difficult to budget for
Compare that to the notes payable option:
- The debt is long-term and paid over a five-year period
- Late payments would hurt the business’s credit score and may result in the financial institution pursuing collateral
- Payment amounts are small meaning less of a disruption to cash flow and easier to budget for
The impact of the debt and how they manage it differs greatly. For the same amount of money, accounts payable must be paid back quickly while notes payable are paid over a longer period with clearer terms and consequences.
How to effectively manage notes payable and accounts payable
Despite their differences, the tactics used to effectively manage both notes payable and accounts payable are similar. Use these practices to improve your debt management.
Know your cash flow
When you take on debt, you need to be mindful of how effectively you can manage the payments.
The crucial aspect of cash flow is when money is entering or leaving the business. You might have outstanding accounts receivables that are set to come in within the next week, but it won’t help you cover your payments now.
If you’re finding yourself getting stressed by debt repayments, think about how you can restructure your sales or operations to have cash coming in before it goes out.
For example, if you have notes payable payments due on the 15th of every month, you could change your invoicing cycle so the due dates of your customers always come before your own payment due dates.
Stay on top of due dates
Missing due dates incurs unnecessary interest and late fees that eat into your margins. Put due dates in your calendar with reminders days in advance so you aren’t blindsided by any payments.
For your accounts payable, review the payment terms as outlined by the vendor. This will set the deadline for when the payment is due as well as any extra costs if you miss the payment.
Your vendors will be more sympathetic to your payment situation than lenders. Reach out preemptively if you’re concerned about a payment being late and see if they’ll be willing to extend.
For notes payables, your payments will likely be for the same amount on the same date every month making it easier to plan for. You should have a payment schedule that would have been drafted as part of the notes payable documentation.
Even for recurring payments, it’s worthwhile to put reminders in your calendar.
Create a comprehensive budget
Think of budgets as a roadmap that helps you get to your destination. They outline how your cash will be allocated so that you can accomplish your financial goals.
Part of your budgeting process should include how and when you’ll be making payments on your outstanding debts.
As you’re budgeting for an upcoming period, think about what upcoming debt payments you have. They should be one of your first considerations when you’re setting your spending levels.
As part of the budgeting process, you’ll start to identify cost-cutting opportunities that will ensure you have the cash on hand to manage any upcoming payments.
Manage vendor relations
Your vendors are business owners as well. They know what it’s like to manage the highs and lows of cash flow.
Making early payments when you can and maintaining strong communication regarding outstanding invoices will help build strong vendor relationships and maybe some leeway for upcoming payment dates.
Remember the golden rule. You know how you’d want one of your clients to handle a late payment, so give the same treatment to your suppliers.
Check your financial statements
Your financial statements contain a wealth of information that helps you get the lay of the land, plan ahead, and forecast the future.
The balance sheet should be the first place you go to look at your total liabilities. You can check your total cash on hand as well to get an idea of whether you can manage your upcoming debt payments.
The cash flow statement provides insight into how money is coming into and leaving the business. You’ll see what portion of your cash outflows are driven by debt payments.
Track the following metrics to understand your current debt situation and monitor that part of your financial health going forward:
- Cash flow-to-debt ratio: How long it would take to pay down a business’s debt if all cash flow was devoted to debt payments. You’ll need your cash flow from operations for a period from a cash flow statement and your total debt from a balance sheet.
- Debt-to-assets ratio: The proportion of assets to debt that a business holds. Look to your balance sheet for your total assets and total debt.
- Debt-to-equity ratio: The proportion of equity to debt that a business holds. Find your total equity and total debt on your balance sheet.
- Interest paid: Total interest expenses paid over a period of time. Interest expenses are a separate line item on the income statement.
- Debt service coverage ratio: A measure of how much of debt payments can be covered by net income. Divide the net operating income found on the income statement by total debt payments.
Automate accounts payable management and more
Cut the stress of managing invoices and sorting out payments with BILL, the ultimate platform for streamlining every step in the accounts payable process.
With effortless invoice capturing, seamless approval, and multiple options for one-click payments, you’ll save time and reduce errors.
Learn more about our accounts payable solution and reach out for a demo.
