Definition:
The average payment period is the measure of days the business takes to pay off accounts payable. It’s a solvency ratio and indicates business practice to satisfy obligations that fall due. The length of the average payment period is dependent on multiple factors including business policies, liquidity, adequacy of financial planning, and pattern of negotiation with the suppliers.
Detailed concept
It’s a business norm to purchase and sell goods on credit, and the length of a credit period varies from supplier to supplier and product to product.
However, some businesses believe in the maintenance of creditworthiness and look for discounts on the early payout. On the contrary, some businesses believe in payable balance as strong input in the working capital and practice to maintain average payment period as long as possible.
So, there are two sides of the equation that include,
- Maintenance of creditworthiness (centered on maintaining working relations with suppliers)
- Management of working capital (centered on enhancing business profitability)
The business managers need to balance these factors for effective management of the average payment period. If managers are more centered on managing working capital with the accounts payable financing, the business may be more profitable in the short term due to more liquidity.
However, it has a massive potential to impair working relations with suppliers and compromise the long-term profit of the business. For instance, if the business takes too long to pay the supplier, they might limit material supply during the season. Hence, the business may have to compromise on long-term profitability.
On the contrary, if the business is more focused on creditworthiness, it may raise more finance and incur interest charges.
Let’s analyze the concept from suppliers’ perspective as they are primary stakeholders in the average payment period of the business. Again, there are two sides of the equation where profitability and liquidity act in a reverse direction.
The components of the equation are followings,
- An early collection of their dues (centered on improving liquidity/funds collection).
- Collection of funds on completion of credit period (centered on improving profitability)
On early collection of the funds, the suppliers may have to offer certain discounts. The percentage of discount allowed on revenue is recorded as an expense, which reduces the business profit. However, the benefit of the early collection is that amount can be utilized in the business.
It can be a desirable credit policy if the business has a higher rate of return as some amount of profit given as a discount is not expected to impact significantly impact on profit. On the contrary, the suppliers may not offer early collection discounts to remain in high profit.
Hence, the average payment period needs to be balanced between liquidity and profitability for an effective business run.
The formula for the average payment period
The given formula can be used to calculate the average payment period,
APP = (average accounts payable) / (total credits / period)
The given formula can measure the average payable period with the application of the following steps.
Steps to calculate the average payment period
Following are the steps to calculate the average payment period.
Step-1
Calculate average balance for the accounts payable – This can be calculated by adding the opening balance of the accounts payable with the closing balance and dividing by two. The calculation can be done as follows,
Average payable balance= (beginning balance + ending balance) / 2
The amount calculated with the formula represents the average balance for the period under consideration. It’s an average of the credit purchases and the payments that have been made for the period under consideration.
Step-2
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.
For instance, if monthly credit purchase amounts to $30,000, it needs to be divided by 30, and per day credit purchase amounts to $1,000 ($30,000/30). Typically, the businesses use the yearly payable period, and the amount for credit purchase needs to be divided by 365.
Step-3
Divide an amount calculated in step 1 (average payable) with the per-day sales calculated in step 2 (credit sales per day). The resultant amount will be the average payment ratio. The figure obtained is a valuable insight that helps to assess the average payment period of the business.
Example of the average payment period
Opening and closing balance of accounts payable for XYZ company amount to $20,000 and $30,000 for the year ended June 31, 2021. The credit purchases during the year amount to $40,000.
We need to calculate the average payment period with the given formula.
Average payable balance= (beginning balance + ending balance) / 2
Average payable balance= ($20,000+$30,000)/2
Average payable balance= $50,000/2
Average payable balance= $25,000
Putting average payable in the formula.
APP = (average accounts payable) / {(total credits / period)}
APP = $25,000 / {$40,000/ 365}
APP = $25,000 / $109.58
APP = 228 days
Advantages of calculating average payment period
Given are some of the advantages associated with the calculation of the average payment period.
- The average payment period helps to understand the cash flow/liquidity position of the business. So, it’s useful with perspective to creditors, investors, analysts, management, and other stakeholders that intend to do business with the company.
- It’s the main component in the financial planning of the business. If the business can assess the right period payable, it can enhance forecasted cash flow.
- The average payment period helps investors to assess if suppliers can trust the business in terms of collection. For instance, if the business has the practice of paying dues on time, suppliers can expect timely receipt of their funds.
Disadvantages of calculating average payment period
Following are some of the disadvantages associated with the calculation of the average payment period.
- A longer payment period is perceived to be desirable. However, it completely ignores the element of discount achieved by the early payout. So, the short payable average can sometimes be more desirable.
- With perspective to working capital management, it’s isolated information that does not add much value in the process of cash management. For instance, other matrices like inventory days and receivable collection need to be calculated to assess the business’s cash position.
- This metric overlooks non-financial factors factor-like customer relations, creditworthiness, trust, and payment history, etc.
Conclusion
The average payment period is the time the business takes to pay off its creditors. This metric is connected with the liquidity perspective of the financial analysis. Often, companies need to manage between qualitative and quantitative factors in terms of credit management.
The companies are often offered discounts on early payment of their dues. So, the companies need to manage between liquidity and profitability.
Further, the average payment period helps to provide strong insights for the overall cash flow activities, allows investors and creditors to assess the business’s creditworthiness, and is considered to be one of the main inputs in financial planning.
However, there are certain drawbacks of the average payment period, like it does not consider qualitative aspects of the relations with the suppliers.
Frequently asked questions
Why is the payment period average important with perspective to an investor?
The average payment period is important from an investor’s perspective because it helps assess the business’s solvency the risk of liquidation.
If the average payable period is more than normal practice, it may indicate a higher liquidation risk. On the contrary, if the average payable period is in line with market practice, it may suggest a lower liquidation risk.
Is lengthy average payment desirable from a business point of view?
With perspective to profitability, a lengthy average period is desirable as it helps to enhance working capital management. However, other factors related to supplier relations need to be considered.
Why is the average payment period important from the supplier’s perspective?
Suppliers are mostly concerned about the timely collection of their dues. 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. On the other hand, if the average payment period of the business is lengthier, they may be reluctant to do business with them.
How lower cost of financing is linked with the higher average for the payment period?
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. Hence, the cost of financing and average payment period are linked as inverse.
What’s the impact of the average payment period on the working capital?
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.
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.
Number of inventory days XXX
Number of receivable days XXX
Number of payable days (XXX)
Working capital days XXX / (XXX)
It’s important to note that shorter working capital is more desirable from a financial standpoint.
