The average payment period needs to be compared to other companies in the same industry as typically, there will be a standard average. Now that you know the exact formula for calculating the average payment period, let’s consider a quick example. The average payment period is arrived at by dividing Credit Purchases by 365 days, and then dividing the result into Average Accounts Payable.
- So, if the average payable period of the business is in line with their credit policy, they feel at ease in doing business with them.
- Otherwise, it may find itself falling short when it comes to paying its own debts.
- While the supplier or vendor delivered the purchased good or service, the company placed the order using credit as the form of payment (and the related invoice has not yet been processed in cash).
- If they have lax collection procedures and policies in place, then income would drop, causing financial harm.
- Thus, it is highly recommended to analyze other companies’ metrics in your specific industry.
In general, the more a supplier relies on a customer, the more negotiating leverage the buyer has in terms of payment periods. This is an in-depth guide on how to calculate Average Payment Period with detailed interpretation, analysis, and example. You will learn how to use its formula to assess a company’s operating efficiency.
Average Payment Period Formula
If this company’s average collection period was longer—say, more than 60 days— then it would need to adopt a more aggressive collection policy to shorten that time frame. Otherwise, it may find itself falling short when it comes to paying its own debts. Alternatively and more commonly, the average collection period is denoted as the number of days of a period divided by the receivables turnover ratio. The formula below is also used referred to as the days sales receivable ratio. Opening and closing balance of accounts payable for XYZ company amount to $20,000 and $30,000 for the year ended June 31, 2021.
This information is valuable for the company’s stakeholders, investors, and analysts, enabling them to make informed decisions. In short, payment period is a sensor for how efficiently a company utilizes credit options available to cover short-term needs. As long as it is in line with the average payment period for similar companies, this measurement should not be expected to change much over time.
AR is listed on corporations’ balance sheets as current assets and measures their liquidity. As such, they indicate their ability to pay off their short-term debts without the need to rely on additional cash flows. 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.
The average collection period is often not an externally required figure to be reported. The usefulness of average collection period is to inform management of its operations. Hence, the average payment period needs to be balanced between liquidity and profitability for an effective business run.
On the contrary, if the average payable period is in line with market practice, it may suggest a lower liquidation risk. However, there are certain drawbacks of the average payment period, like it does not consider qualitative aspects of the relations with the suppliers. A good average payment period is one that aligns with the industry average or that of comparable companies. By computing it, you can assess the appropriateness of your payment terms, credit policies, and choice of business partners. In addition, a higher DPO may mean several things and usually must be further investigated as the figure by itself doesn’t mean much.
Example of the average payment period
Average collection period is calculated by dividing a company’s average accounts receivable balance by its net credit sales for a specific period, then multiplying the quotient by 365 days. Companies having high DPO can use the available cash for short-term investments and to increase their working capital and free cash flow (FCF). The company may also be losing out on any discounts on timely payments, if available, and it may be paying more than necessary. The reason that the company wants you to calculate the https://simple-accounting.org/ is that they want to be as lean as possible in its operations. 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.
The average payment period is how long it takes on average to pay back vendors. It can be used to compare companies against each other or the industry average. 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. Real estate and construction companies also rely on steady cash flows to pay for labor, services, and supplies.
Calculate credit sales per day– The amount can be calculated by summing total credit purchases in a specific period and dividing by the number of days. The average collection period ratio measures the average time it takes for a company to collect receivable balance from its customers. It shows the efficiency of the company’s credit and collection policies related to receivables and cash flow.
Benefits of Calculating Average Payment Period
The average payment period is a measurement of how long a time it takes on average for a business to pay back its creditors. Calculating this requires dividing the amount of credit purchases by the 365 days in a year, and then dividing this amount into the total accounts payable for the year. Companies use the average payment period to see how efficiently they are paying back their creditors, thus assuring that payments are being made in a prompt manner.
Real-World Example of DPO
The management team will use this information to determine if paying off credit balances faster and receiving discounts might produce better results for the company. The average payment period counts the number of days it takes a company, on average, to pay off its outstanding supplier or vendor invoices. A higher AP Turnover ratio shows more frequent payments to suppliers, reflecting possibly stringent payment terms or a strategy to maintain strong supplier relationships. A lower ratio shows less frequent payments, which could be a sign of cash flow management or potential cash constraints.
A shorter APP shows that the company is paying its suppliers relatively quickly, which can be because of favorable payment terms or effective cash management. A longer APP suggests that the company is taking longer to pay its invoices, which could be a strategy to manage cash flow or show potential cash flow issues. You do that by dividing the sum of beginning and ending accounts payable by two, as you can see in this equation. However, you have to try and strike a balance as taking as long as possible to pay creditors can result in the company having more money which is good for working capital and available cash flows. If the payment period of the business is higher, they are expected to raise a lower amount of finance. If the amount to be paid as payable can be utilized in working capital management.
All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Go a level deeper with us and investigate the potential impacts of climate change on investments like your retirement account. The reason for using the average balance, rather than the ending balance, is to ensure consistency in the timing of the ratio. For example, a company can see whether its DPO is improving or worsening over time and make the appropriate course of action accordingly. Understand the significance of accounting cycle in finance, the crucial steps and guidelines to follow.
The best way that a company can benefit is by consistently calculating its average collection period and using it over time to search for trends within its own business. The average collection period may also be used to compare one company with its competitors, either individually or grouped together. Similar companies should produce similar financial metrics, so the average collection period can be used as a benchmark against another company’s performance.
For instance, an increase in the inventory and receivable days adversely impact the working capital, and the reverse is true in the case of the payment period, as shown in the formula. A higher average payment period is desirable from a working capital perspective, and it’s the only item in the sales cycle that positively impacts the working capital cycle. With perspective to profitability, a lengthy average period is desirable as it helps to enhance working capital management. If the average payable period is more than normal practice, it may indicate a higher liquidation risk.
The average payment period is determined by dividing the accounts payable by the average credit purchases per day. In this case, it would be $60,000 USD divided by $2,000 USD, which yields a quotient of 30. The average payment period calculation can reveal insight about a company’s cash flow and creditworthiness, exposing potential concerns. Or, is the company using its cash flows effectively, taking advantage of any credit discounts?