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As the saying goes, in business, you have to spend money to make money. Although the gravity of business expenditures might not be fully realized until you’re actually up and running, businesses at every stage spend money on a daily basis. Rent, payroll, new machinery, office equipment, and raw materials are just a few different expenses that companies incur regularly.
Many times, business leaders make purchases using some sort of debt, either through a loan or line of credit with a supplier, instead of dipping into their existing cash reserves. When procuring goods or services that your business needs to conduct daily operations, hit strategic growth targets, or expand into new product lines, there are two main ways to track money that you owe: accounts payable and notes payable.
While both accounts payable and notes payable refer to business liabilities, their use cases within the procurement process as well as their financial implications are different. By understanding the similarities and differences between accounts payable vs. notes payable, you can unlock debt financing in a safe, well-managed way.
What are Accounts Payable?
The short-term debt obligations that a business must pay in order to run the business are called “accounts payable.” After onboarding a new vendor or supplier, drawing up a purchase order, and placing an order with them, you’ll owe them money for the goods or services they provide.
The accounts payable team will eventually receive an invoice associated with each transaction, and from there, through a series of AP internal controls, they’ll confirm that the invoice is correct and begin the payment process to the entity that sent the invoice. Since these types of debt are short-term, usually with 30, 60, or 90-day payment terms, they’ll be listed on your balance sheet as a current liability and paid within the defined terms.
Accounts payable agreements are less formal than notes payable; there are usually no legal contracts involved and only the specific cost of the goods or services provided will be owed. As long as buying companies make invoice payments on time, there should be no additional late fees or penalties incurred. However, if you do fail to meet these debt requirements, vendors could refuse to continue doing business with you, jeopardizing critical aspects of your business.
What are Notes Payable?
Notes payable are still debt obligations, but these formal agreements usually refer to money a business owes to a bank or financial institution. They are usually for larger sums of money than any accounts payable transaction would be, and are often considered a long-term liability because of the extended payback period. You may need notes payable to secure the funds for strategic business investments or long-term projects.
If you received a loan from a bank with a 5-year payback period, any amount that your business is expected to pay back within the first year would be a short-term liability, while the remaining total would be tracked by the accounting team as a long-term liability. Another major factor of accounts payables vs. notes payables is that with notes payables you will usually have to pay the lender back with interest.
This means that if the loan you took out was for $50,000, by the time you pay the debt off in full, you’ll incur more than $50,000 in expenses due to interest fees. Be sure to understand the implications that interest will have before entering into a notes payables contract. In the US, since interest rates are very high, taking on this kind of debt is more expensive than it has been in recent years.
You might have heard of a promissory note, which is a common type of note payable used in business transactions, but there are many types of notes payables structures all business leaders should be aware of.
Single Payment
With single-payment notes payables, you will be required to repay the principal amount that you received from the lender as well as any interest incurred all in one payment. The lump-sum repayment date will be set at the very beginning of the notes payable process, so you’ll be able to anticipate a large cash payment when the time comes.
Amortized
An amortized notes payable agreement is most often used for home, property, or building loans. These promissory notes will stipulate monthly payments that are the same amount month-over-month, with a portion of each payment going toward the principal balance and the interest owed. The longer you pay back the loan, the more of each monthly payment will go toward the principal amount instead of interest.
Negative Amortization
Negative amortization notes payables allow you to make low payments each month that do not cover the interest incurred. Unpaid interest will then be added to the principal balance, and while this might be a helpful structure to keep monthly costs low at first, you’ll end up paying more in the long run.
Interest-Only Agreements
This structure means that you’ll only pay the interest fees on a monthly basis. At the end of the life of the note, you’ll pay the entire principal amount back in a lump sum payment.
Accounts Payable vs. Notes Payable: What are the Differences?
The difference between notes payables and accounts payables is more than just the fact that notes payables are usually for larger sums of money; these two debt obligations are used differently in business, require different accounting processes, and have many other differences. Accounts payables vs. notes payables are differentiated by the following:
Business Use Case
Generally, notes payable will not be used when paying a vendor for raw materials, and accounts payable isn’t the right way to classify a business loan. NP is used if you’re partnering with a bank, creditor, or financial institution to obtain additional funds, and AP is used when vendors or suppliers provide your business with the goods and services needed to maintain day-to-day operations. Since the business application of accounts payable vs. notes payable varies, everything else that follows also varies.
Duration
As mentioned, NP refers to long-term liabilities; repaying this type of business debt usually extends beyond the current calendar year. On the other hand, accounts payable is only for short-term liabilities that will be paid back within the next 12 months.
Accounting Activity
When looking at accounts payable vs. notes payable, it’s important that your accounting team has a solid understanding of the differences, because AP and NP require a different method of tracking and being recorded in the general ledger. The short-term nature of accounts payable makes it so that they are filed as a current or short-term liability while notes payable are usually a long-term liability. Getting this component reduces errors in the account reconciliation process and enhances the accounting cycle as a whole.
Formality
In the procurement process where a purchase order is used, there is a contractual agreement involved between your business and the supplier or vendor, but the legal obligations are nowhere near as serious as the agreements used in a notes payable situation between a business and a financial institution.
Risk
Since most businesses are interested in maintaining good relationships with their suppliers and ensuring that invoices can be paid on time, accounts payable transactions are more low risk than notes payable contracts. Notes payable have a longer lifespan and are usually for much larger sums of money. On top of that, they’ll accrue interest over time. If your business hits a rough patch and experiences decreased cash flow, the risk associated with long-term liabilities is much higher.
Payment Recipient
When the accounts payables team makes a payment, the recipient of that payment is a person or business that provided the goods or services in question. With notes payable, the recipient is a bank or financial institution that can have more of an impact on your creditworthiness as a business.
Procurement Benefits of Accounts Payable
Streamlined procurement management plays a critical role in overall business health. Being able to obtain the goods and services your business needs to operate optimally is one of the biggest hurdles for any business owner. Accounts payable ensures proper repayment to vendors and suppliers, but it goes further than that. Effective AP management will bring many benefits to the procurement process:
- Long-lasting business relationships
- Reduced late or missed payment fees
- Better credit terms with suppliers
- Early access to new or enhanced products from vendors
- Insightful AP reports
Procurement Benefits of Notes Payable
Making strategic investments in a business can be challenging. Scraping together the funds for a large purchase or new expansion project can feel nearly impossible with tight margins but notes payable make the procurement process of major investments all the more possible.
Since accounts payable vs. notes payable breakdowns remind us that notes payable are most often used to secure the funding for things like new office space, R&D projects, and costly machinery, it’s clear that notes payable can make the future of your business that much more attainable.
Conclusion
If you’re in the startup stage, trying to get your business off the ground, securing lines of credit with suppliers via accounts payable will be one of the most effective ways to get what you need to run your business before you have a lot of money coming in. As your business grows and changes, you may need to change your strategic focus or invest in new areas of your business. The funds from notes payable will make that possible. Even if you’re happy with the cash you have coming in and the way your expenses are managed, notes payable and accounts payable can be used as strategic cash flow management measures.
So, while you are spending money to make money, keeping a pulse on the multiple use cases, benefits, and structural differences between accounts payable and notes payable could be the key to unlocking the next chapter for your business. If you feel like your baseline understanding of both is there, but you want to be able to manage them more proactively, consider investing in accounts payable software to take this area of your business up a notch.
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