What is the average payment period formula?
The following formula can be used by bookkeepers, accountants, and other corporate finance experts to determine the typical payment period:
APP = (average accounts payable) / (total credits / days)
The average accounts payable value in the formula is the average of the accounts payable’s beginning and ending balances. The sum of all business credit purchases is represented by the total credits value. The number of days within the period that you’re measuring could also serve as the period, or days, rather than a fiscal year.
What is average payment period?
The days payable outstanding (DPO) ratio, which measures a company’s solvency, measures how long it takes a company to pay its short-term liabilities, particularly for purchases it makes on credit. An essential financial metric for companies to assess how well they settle their debts quickly is the average payment period. Most businesses measure APP once a year, but some do so every quarter or according to the deadlines set by creditors.
Advantages of average payment period
Numerous applications can benefit from knowing your organization’s typical payment period, including:
Provides insight into overall cash flow activities
The APP ratio of a company can provide important information about its overall financial operations. The APP displays the typical time businesses take to use revenues for covering these types of costs. Incoming cash flow that businesses generate is advantageous for funding investments, paying down liabilities, and covering operational expenses. Where to allocate funds and resources to best support credit payments can be determined by understanding how your company uses its incoming cash to pay for its liabilities.
Allows investors to gauge credit worthiness
A company’s APP ratio is used by shareholders, investors, and other financiers to assess whether it has sufficient incoming revenue to cover short-term liabilities and how quickly the business can pay them off. Investors can use this information to determine whether it is advantageous to fund business ventures. In order for banks and other financial institutions to approve business loans or lines of credit, the APP also provides them with the data they need.
Shows how efficiently companies can cover short-term liabilities
Investors and creditors can ultimately determine how quickly a company can pay off its debt and credit obligations by looking at its average payment period. Companies can occasionally benefit from discounts from suppliers or vendors on credit purchases as long as they can settle the outstanding balance within a certain amount of time.
For instance, if the balance is paid by the due date specified by the supplier, a business may receive a 10% discount on its purchases from the supplier. Suppliers are more likely to provide special payment rates if the company’s APP demonstrates that it is capable of quickly paying off its credit balances and covering its immediate expenses.
How to calculate an average payment period
APP = (average accounts payable) / (total credits / period)
Follow these steps to determine the average payment period using the formula:
1. Determine the average accounts payable
You must first determine the average value of your company’s accounts payable in order to determine the average payment period ratio. This amount can be calculated by summing the accounts payable’s beginning and ending balances, then dividing the result by two. The formula for the average accounts payable is:
AAP = (beginning balance + ending balance) + 2
2. Divide total credit purchases by days in the period
You can calculate the remaining components of the APP formula once you know the average accounts payable. Divide the total amount your company spent on credit purchases during the measurement period by the number of days in the period to use the formula.
Most of the time, businesses track APP annually, giving the formula a value of 365 days. Likewise, depending on the precise length of time you want to track, the number of days in the formula can be altered. For instance, the formula would use 90 days to represent a quarterly cycle.
3. Divide this result into the average accounts payable
Divide the result of dividing the total credits by the time period by the average accounts payable. The end result gives you the average payment period ratio, which can give you important information about the cash flow processes and general financial health of your organization.
4. Evaluate the average payment period ratio
The APP essentially demonstrates a company’s ability to pay for the credit purchases it makes. Understanding how your company pays its obligations both on time and financially can help you identify areas where processes could be streamlined and strategies could be improved. For instance, a business can assess its cash flow activities using its APP, including revenue-generating collection processes.
Disadvantages of APP
Aside from its benefits, using APP in cash flow analysis has some disadvantages as well:
Ignores qualitative business factors
The average payment period only demonstrates data calculations and excludes any qualitative elements that might influence a company’s credit coverage. For instance, a company’s relationships with its clients can affect how it manages and collects payments. Due to the impact that customer payment collection can have on cash flow, qualitative elements like balance forgiveness or past-due customer accounts may have an impact on how quickly businesses can generate enough revenue to cover liabilities. However, the APP does not consider these kinds of factors.
APP only shows information for liabilities
The typical payment period only considers a company’s credit and payments due to its creditors or investors. The state of the business’s accounts receivable and outstanding customer payments, which are essential elements of its revenue, are not taken into account by this metric. For instance, a company’s accounts receivable balance might indicate that clients have finished a purchase but not yet finished the payment cycle, deferring actual payment to a later time. However, the APP doesn’t consider this potential cash flow when determining whether or not the company can afford to pay its debts.
Example of APP
Assume for the purposes of this illustration that a manufacturing business regularly purchases some of the raw materials it needs for production on credit. The company is looking for a new supplier who wants to know the average payment period of the business in order to establish a credit plan.
The accountant determines the average accounts payable using the formula AAP = (beginning balance + ending balance) + 2 to arrive at the following result if the beginning balance of the accounts payable is $219,000 and the ending balance is $231,000:
AAP = ($219,000 + $231,000) + 2 = $450,000 + 2 = $225,000.
The accountant adds up all of the credit purchases the company made during the time period after calculating the average accounts payable. Since the accountant is calculating the APP for the entire year, if the company’s credit purchases total $1,750,000 over a 365-day period,
The accountant uses the formula APP = (average accounts payable) / (total credits / period) to determine the average payment period using the average accounts payable value of $225,000, the company’s credits of $1,750,000, and the period. The result is:
Amount Per Day (APP) = ($225,000) / ($1,750,000 / 365 Days) = ($225,000) / (4,794) 52) = 47 days.
This value informs the accountant that the company pays off its short-term liabilities on average every 47 days. This period of time is effective because it demonstrates that the business has sufficient incoming cash flow to cover its liabilities and the ability to pay them off on schedule.
Average Payment Period
FAQ
How do you calculate average payment date?
- For convenience, use the first due date as the starting day, base date, or “O” day.
- Add up the days from the base date to each due date.
- Multiply the number of days by the amounts.
- Add up the amount and products.
Is a high average payment period Good?
A shorter payment period indicates prompt payments to creditors. The company’s creditworthiness is also indicated by the average payment period, which is similar to the accounts payable turnover ratio. However, a very brief payment period might be a sign that the business is not fully utilizing the credit terms supplied by suppliers.
