What is the Average Payment Period?
Businesses and organizations rely on credit for some of the key processes and operations that support revenue generation. Companies may purchase necessary assets on credit and depend on investors for funding key business aspects. The average payment period is an essential financial metric that allows businesses to understand how efficiently and quickly revenues can cover the costs of these credits.
Average payment period (APP) is a solvency ratio that measures the average number of days it takes a business to pay its vendors for purchases made on credit.
Average payment period is the average amount of time it takes a company to pay off credit accounts payable. Many times, when a business makes a purchase at wholesale or for basic materials, credit arrangements are used for payment. These are simple payment arrangements that give the buyer a certain number of days to pay for the purchase.
There are several advantages that come to a company that tracks their average payment period. But the biggest benefit comes from the average payment period being a solvency ratio. A solvency ratio helps a company determine its ability to continue business as usual in the long-term. It does this by measuring the company’s ability to pay back its obligations.
There are many reasons for a company to use the average payment period. At the basic level, it only tells the average length of time it takes for a company to pay back its vendors. This can help a company make decisions on cash flow. Additionally, it can help them look for discounts available when they choose to pay vendors sooner rather than later.
The formula of Average Payment Period Ratio
The average Payment Period can be calculated using the below-mentioned formula.
Average Payment Period Ratio = Average Accounts Payable ÷ (Total Credit Purchases / Days)
Where,
- Average Accounts Payable = It is calculated by firstly adding the beginning balance of the accounts payable in the company with its ending balance of the accounts payable and then diving by 2.
- Total Credit Purchases = It refers to the total amount of credit purchases made by the company during the period under consideration.
- Days = Number of days in the period. In the case of a year, generally, 360 days are considered.
How to calculate an average payment period
Using the formula, calculate the average payment period with the following steps:
1. Determine the average accounts payable
Before calculating the average payment period ratio, you need to know the average value of your business’s accounts payable. You can find this value by adding the beginning and ending balances in the accounts payable and dividing this sum by two. The formula for the average accounts payable is:
AAP = (Beginning balance + Ending balance) ÷ 22. Divide total credit purchases by days in the period
Once you know the average accounts payable, you can calculate the rest of the APP formula. In the formula, divide the total amount your business spent in credit purchases for the period you’re measuring by the number of days in the period.
In most cases, businesses typically track APP yearly, giving a value of 365 days for the formula. The number of days in the formula can change, too, depending on the specific amount of time you want to track. For instance, a quarterly cycle would represent 90 days in the formula.
3. Divide this result into the average accounts payable
After dividing the total credits by the time period, divide this result into the average accounts payable. The final result gives you the average payment period ratio, which can provide valuable insight into your organization’s cash flow activities and overall financial health.
4. Evaluate the average payment period ratio
Essentially, the APP shows how well a company can cover the costs of the credit purchases it makes. Understanding the how your business covers its liabilities both financially and on time can show you where the business can benefit from improvements to strategies and more streamlined processes. For instance, a company can use its APP to evaluate its cash flow activities, including collections processes that generate revenue.
Average Payment Period Example
Let’s say that you want to calculate the average payment period for a company that manufactures various styles of Bluetooth headphones, called Blue Ears, Inc.
Most of the parts that are used in the headphones are purchased on credit. The reason that the company wants you to calculate the average payment period is that they want to be as lean as possible in its operations. So they want to see if, on average, they are taking advantage of discounts. These discounts are offered when bills are paid within 30 days since the payment terms are 10/30 net 90. Because you are looking for the yearly average you ask to see the previous years financial statements.
Once you get the statements you look at the years beginning and ending account payable balances. Last year’s beginning accounts payable balance was $110,000 and the ending accounts payable balance was $95,000. Over the course of last year, the company made a total of $1,110,000 purchases on credit.
Let’s break it down to identify the meaning and value of the different variables in this problem.
- Beginning Accounts Payable: $110,000
- Ending Accounts Payable: $95,000
- Average Accounts Payable: $102,500 ( (110,000+95,000)/2 )
- Total Credit Purchases: $1,110,000
- Days within Period: 365
We can apply the values to our variables and calculate the average payment period:
APP = 102,500 ÷ (1,110,000 ÷ 365) = 33.7days
In this case, the average payment period would be 33.7 days.
What this means for Blue Ears is that they are running relatively lean. And they are not receiving any late penalties on their purchases. However, if they pay their vendors just 4 days sooner, then they would be eligible for a 10% discount on their parts and materials.
The recommendation made to the company after seeing this should be that Blue Ears should pay the vendors within the first 30 days. Doing this would be a small and “easy” change that would increase profit margins. What company wouldn’t want an additional 10%?
Average Payment Period Analysis
Paying attention to discount opportunities can mean cash-in-pocket for companies. Many vendors offer payment terms such as net 30,60 or 90 days. This means that the full invoiced amount is must be paid to the vendor 30, 60 or 90 days after the invoice date. Anything after that due date would be subject to a late penalty. However, to incentivize companies to pay sooner, a company may also offer a payment option such as 10/30 net 60. This means that the company has 60 days to pay the invoice with no penalty. However, they would receive a 10% discount if the amount is paid in full within the first 30 days after the invoice date.
Another use for the average payment period is to determine how efficiently a company uses its credit in the short term. Also, it examines its ability to pay its vendors in the long-term. If a company generally pays its vendors quickly and on time might result in the company being offered better payment terms from new or existing vendors.
Something that is very important to consider when beginning to calculate the average payment period for a company is the number of days within a period. For instance, if you are viewing the annual financial statements but need to be doing a quarterly report, the numbers may be different from one to the next. In our above example, what if you had been doing a quarterly report but used the same numbers from the annual report. If you plugged in 90 days for the days within the period, it would look like Blue ears pays its vendors within 9 days of invoicing instead of the actual 34 days. This can cause wrong decisions to be made which might have catastrophic consequences for the company in the short term.
Advantages of Average Payment Period
Below are some of the advantages which are as follows,
- There are various times when the company makes the purchases in bulk or normally as per its requirement. For the payment against this, credit arrangements facilities, as given by the suppliers, are used, which gives some days period to the buyer for making the payment for the purchase made by them. So, it helps know the average number of days taken by the company during the period under consideration to repay the suppliers against their dues.
- The calculation of the average payment period by the company can tell about the different information of the company such as the cash flow position of the company and its creditworthiness, etc., which is useful for many of the stakeholders of the company, especially the investors, creditors, management, and the analysts, etc. to make the informed decision with respect to the company.
Disadvantages of Average Payment Period
Below are some of the disadvantages which are as follows,
- The average payment period calculation only considers the financial figures. It ignores the non-financial aspects such as the relationship of the company with its customers, which may be useful for the analysis of the creditworthiness of the company by its stakeholders.
- The information on the average payment period is useful for the business. Still, at the same time, it is not sufficient to make the decision about the matters of cash management and credit worthiness of the company. For this, other information such as the average collection period and inventory processing period, etc. are also required.
Average Payment Period Conclusion
- The average payment period is how long a company takes on average to pay back their vendors.
- The average payment period can be used to compare various companies against each other as well as the industry average.
- It can be used to analyze a company’s ability to use credit over the short term as well as pay vendors in the long term.
- The formula for the average payment period requires 3 variables: average accounts payable, total purchases on credit, and the total number of days within the period.