Average Payment Period (APP) | Formula, Explanation and Analysis

Introduction

The average payment period is vital for any critical decision making since it provides essential insight into a company’s cash flow process and creditworthiness. It could answer important questions in a business such as: will the company meet its financial obligations?

What is Average Payment Period?

The Average Payment Period (APP) is the average time period taken by a company to pay off their dues against the purchases made on a credit basis from the supplier.

How is the average payment period calculated?

Average payment period formula is as follows:

i.e. Average payment period = Average Accounts Payable * Days in Period / Total Credit Purchases.

Where, 

• Average payable period ratio is the average money owed by a company to its suppliers as per the balance sheet.
• Total Credit Purchases is the total amount of credit purchases made by the company during a particular period of time. 
• Days: Total number of days in the period. (In the case of a year, it is considered 365 days)

Average payment period example

Let’s assume a company A made a total credit purchase worth $1,000,000 in the year 2019. For that year, the initial balance of the accounts payable was $350,000, and the ending balance was $390,000. Using only this information, we have to calculate the average payment period ratio of the company A. 

Before beginning the calculation, let’s assume that the total number of days in a calendar year is 365 days. 

Therefore,

• Initial balance of the accounts payable company: $350,000
• Ending balance of the accounts payable company: $390,000
• Total credit purchase during the year 2019: $1,000,000
• Number of days in the period: 365

The average accounts payable= ($350,000 + $390,000)/2 = $370,000

And, average payment period= $370,000/($1,000,000/365) = 135 days

Therefore, after the calculation we found that the average payment period of the company is 135 days in the accounting year 2019.

Why is the average payment period calculated?

Average payment period helps the key stakeholders and decision makers identify how quickly the company can pay off their credit purchases and liabilities. If the number is good, the company can also take advantage of discounts offered by suppliers for a specific time period. Let’s look at some other reasons to calculate average payment period:

1. Enough time to arrange the money

Credit arrangements are facilitated from the supplier’s end whenever a company makes a bulk purchase. This enables the company to arrange the money in that time period. Thus, it helps calculate the average number of days the company takes to repay the supplier against their dues. 

2. Average payment period ratio tells a lot about the company

Calculating the average payment period helps acquire a lot of information about the company, such as the company’s cash flow position, creditworthiness, and much more. This information is valuable for the company’s stakeholders, investors, and analysts, to make bold decisions for the company.

What are the limitations of only calculating average payment period

1. Average payment period neglects the non-financial aspects of the company

2. Average payment period can’t act solo

Points to remember while calculating average payment period

1. What is the average accounts payable of the company?

Before calculating the average payment period, you need to calculate the average accounts payable of the company. This figure might be present on the balance sheet of the company. 

2. What is an ideal average payment period?

An ideal average payment period is considered to be 90 days by many companies. Any payment significantly higher than 90 days would indicate that the company is taking too long to pay off its credit. A short average payment period however, indicates that the company is making quick payments to its customers without any delay. 

NOTE: Very short average payment period also indicates that the company is not taking full advantage of credit terms allowed by the supplier. 

3. Are you getting any discount for prompt payment?

If the supplier is offering any discount for prompt payments, then you need to compare the amount of discount offered and the benefit of credit length offered to choose the best fit. 

Conclusion

The average payment period is a vital solvency ratio of any company that helps track the ability to pay the amount payable to the supplier. For investors and stakeholders, knowing the average payment period helps in making necessary decisions and can also trigger good investments. If a company’s average payment period is lower than its competitor’s, then it indicates that the company’s ability to pay off the debt is higher than the rest.

In short, the average payment period is an indicator of how efficiently the company utilizes its credit benefits to cover its short-term need for supplies.

FAQs

1. What is a good average payment period?

2. Should the average payment period be high or low?

3. What does an average collection period of 30 days indicate for a company?

4. Is Average Payment Period and Average Collection Period same?

5. How is the average payment period calculated?