Average Payment Period
The average payment period is the solvency ratio which is the average time that takes the company to pay off credit account payable. Sometimes when firm making the purchase for wholesale or the basic material than for payment credit management requires.
This the simple arrangement for the payment through which some days give to the buyer to pay for that purchase.
Definition: What is the Average Payment Period?
For example, if the credit term is 15/30 then it means that if the buyer pays the balance within 30 days then the company give 30 % discount to the buyer.
If the buyer can’t pay then the standard credit term is 0/90 which means that the buyer must pay the balance in 90 days.
From the calculation of the average payment period, we can know about the worthiness and cash flow of the company and exposing potential concern.
Because of this average payment ratio analysts, investors, and the management of the company know about the cash flow of company that runs effectively or not, Or the company take credit from the discount offers or nor, or company meet the current obligation or not.
For the calculation of this ratio first, need to locate the payable information on the balance sheet. Mostly for the calculation of this ration one year worth of the company use. This value may be on a quarterly basis or other bases. So from the desired period of time, it may dictate that which financial statement need to use.
From the following formula, you understand how to calculate the average payment period.
Average Payment Period Formula
Average payment period can be calculated by divide the average payment accountable by the derivation of total credit purchase and day in time. That is :
average payment period=average account payable/(total credit purchase/days)
To find the average payable account which put in the formula we need to sum the beginning and ending payable accounts balance and then divided it by 2. Mathematically it can be written as
Average account payable=(Beginning + ending AP balance)/2
The result of this calculation we need to put in the above formula to get the result of over the age payment period.
We can directly put this value in the above formula instead of average account payable like this
Average payment period=(beginning + ending AP balance)/2/(total credit purchase)/days
Average Payment Period Example
Now we take the example of a cloth manufacturer company from wholesale textile marker which purchases regularly material on credit.
This company has a great forecast sale because of which management makes the lean plan for sales to get more profit from sales.
Management can see the average payment period of the company’s previous year. And then observe that with such credit how the company is efficient.
For the calculation of average payable account, we need the beginning average payable which is $200,000 and ending average payable which is $205,000. In one year total credit purchase $875,000. Now we can calculate the average account payable from the above value such as.
Now we put the result of average account payable in the average payment period formula such as
From the above result, we know that the company operates the average payment period in 84 days. From the above result, it is easy for management to determine the result of the company.
The result is good if the payoff credit balance is fast and receiving discount produce a good result.
Analysis and Description
Form the above scenario if we look at the average payment period then it is rather long payment period. If the company take a long time to pay then it may be the crucial saving. If we assume that for one main supplier’s company give a 10% discount if the supplier pays within 60 days.
Then management needs to analyze that there is adequate cash flow for 60 days to cover the purchase have the company or not. If the company has, then it is good for the company because for the clothing industry 10% is a huge difference.
It is necessary for the clothing industry to keep the money for the entire period and give the early pay discount to its customer.
Then due to early pay discount company collect more cash flow for the investment which gives the result of high turnover inventory. So because of this in the new inventory to invest 10 % more.
For the evaluation of the cash flow of the company average payment period is the best measurement.
If you are interested then you can learn more about:
Asset coverage ratio