Average Payment Period: What Is It and How to Calculate It? [+ Examples]

Introduction

The average payment period is a critical metric for businesses, providing vital insights into cash flow and creditworthiness. It answers essential questions: Will the company meet its financial obligations? In essence, it reveals how long your company typically takes to settle outstanding bills with suppliers.

This ratio serves as a financial health indicator. By computing it, you can assess the appropriateness of your payment terms, credit policies, and choice of business partners.

What is the 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:

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 Calculation Example

For instance, consider a scenario where your company made a total credit purchase worth $1,000,000 in the year 2022. For that year, the initial balance of the accounts payable was $350,000, and the ending balance was $390,000. Using this information, your calculation would be:

But before beginning the calculation, you need to calculate the average accounts payable by plugging numbers into average accounts payable equation = 

($350,000 + $390,000)/2 = $370,000

Why Calculate Your Average Payment Period?

Knowing your average payment period ratio gives you the power to manage it. It helps key stakeholders and decision-makers identify how quickly the company can pay off its credit purchases and liabilities. If the number is favorable, the company can take advantage of discounts offered by suppliers for a specific time period. 

Also, calculating the average payment period provides valuable information about the company, including its cash flow position, creditworthiness, and more. This information is valuable for the company’s stakeholders, investors, and analysts, enabling them to make informed decisions.

Limitations of Average Payment Period 

The average payment period is a valuable metric, but it does not reveal everything about the company’s cash management system. You need other measures such as collection period, inventory processing and so on, to know how quickly you can collect receivables. 

Let’s check out the other limitations of average payment period: 

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

   The average payment period only accounts for the company’s financial figures, which in some way disregards the non-financial aspects. This can also include the company-client relationship which is vital to understand business’s creditworthiness.

2. Average payment period can’t act solo 

   Knowing the average payment period alone, is not enough to make decisions regarding the company’s cash management process. It requires external support from metrics such as average collection period.

Points to Remember While Calculating Average Payment Period

1. Before calculating the average payment period, you need to determine the average accounts payable of the company. This figure may be found on the company’s balance sheet.
2. Many companies consider an ideal average payment period to be around 90 days. A payment period significantly longer than 90 days suggests that the company is taking too long to settle its credit, while a shorter average payment period indicates that the company makes prompt payments to its suppliers.

   NOTE: An extremely short average payment period may also imply that the company is not fully capitalizing on the credit terms provided by the supplier.

3. If the supplier offers discounts for early payments, it’s essential to compare the discount amount with the benefits of extended credit terms to make an informed choice.

Wrapping Up

The average payment period is a crucial solvency ratio for any company as it tracks the ability to settle amounts owed to suppliers. For investors and stakeholders, understanding the average payment period is essential for making informed decisions and identifying potential investment opportunities.

If a company’s average payment period is shorter than that of its competitors, it signifies that the company has a higher capacity to repay debts compared to others.

In summary, the average payment period serves as an indicator of how efficiently a company leverages its credit advantages to meet its short-term supply needs.

Ensuring timely collections enables timely payments, creating a positive cycle of financial efficiency.

FAQs

1). What is a good average payment period?

A good average payment period is one that aligns with the industry average or that of comparable companies.

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

A low average payment period is preferred, as it signifies that the company takes less time to settle its outstanding supplier invoices.

(Note: An excessively short average payment period may suggest that the company is not fully utilizing the credit terms offered by its suppliers.)

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

An average collection period of 30 days indicates that the company typically collects its accounts receivable within a 30-day timeframe.

4). Are the average payment period and average collection period the same? 

No, they are not the same. The average payment period represents the average number of days a company takes to pay its supplier invoices. In contrast, the average collection period reflects the average number of days it takes for a company to collect and convert its accounts receivable into cash.

5). How is the average payment period calculated? 

The average payment period is calculated by dividing the average accounts payable by the product of total credit purchases and the total days in a year.

6). What is another name for the average payment period?

Another term for average payment period is “average days payable.