Average Payment Period Definition
The average payment period (APP), also known as the average payable period, is a financial metric used to find out how long a company takes to clear its payables.
It measures the company's payment practices and efficiency in managing its accounts payable balance.
How is the Average Payment Period Calculated?
The average payment period is calculated by dividing pending payment by the cost of goods sold (COGS) and multiplying this by the number of days in the period.
Average Payment Period Formula = (Accounts Payable/Cost of Goods Sold) × Days in Period
A shorter average payment period ratio shows that the company makes invoice payments relatively quickly, which can be because of favorable payment terms or effective cash management. A more extended APP suggests that the company takes longer to pay its invoices, which can be a strategy to manage or show cash flow issues.
The average payment period varies widely across industries and companies. Factors like industry norms, bargaining power with suppliers, net terms, and the company's overall financial health are vital in determining the average payment period.
Companies sometimes deliberately extend their APP to improve their cash flow. This is done by negotiating longer payment terms with suppliers. This must be balanced against the risk of damaging relationships with suppliers or incurring additional costs like late payment fees.
Average Payment Period Example
Assume the following information for a company:
- Accounts Payable at the end of the year: $50,000
- Cost of Goods Sold (COGS) for the year: $300,000
- Number of payable days in the year: 365
Plugging in the values:
APP= (50,000/300,000) × 365
Based on the given values, the average payment period for the company is 60.83 days.
This means, on average, the company takes around 61 days to pay its suppliers.
Average Payment Period vs. Average Collection Period
The average collection period ratio measures a company's time to collect receivable balance from its customers. The ratio, showing the average receivables, indicates the efficiency of the company's credit and collection policies.
The average accounts receivable collection period formula is:
Average Collection Period = (Accounts Receivables / Net Credit Sales) × Number of Days
Where
- Accounts Receivable AR is the total amount of money owed to the company by its customers from credit sales.
- Net Credit Sales is the total revenue from credit sales minus returns and allowances.
- The Number of Days in a Period is the period, which is a year.
The ACP shows the average number of days it takes for a company to collect payments from its credit sales.
Average Payment Period vs. Accounts Payable Turnover Ratio
This ratio measures how often a company pays off its suppliers.
A higher AP Turnover ratio shows more frequent supplier payments, reflecting possibly stringent payment terms or a strategy to maintain strong supplier relationships. A lower ratio shows fewer recurring payments, indicating cash flow management or cash constraints.
Average Payment Period Importance
- Cash Flow Management: APP helps understand cash flow dynamics. A company can manage its cash reserves and plan for the future by knowing how long it takes to pay suppliers.
- Credit Policy Evaluation: It aids in evaluating the effectiveness of the company's credit policies (includes credit sale, credit purchase). The company can miss opportunities to use the credit term if the APP is too short. If it is too long, it can show cash flow issues or strained supplier relationships.
- Benchmarking and Performance Analysis: Companies can use APP to benchmark against industry standards or competitors. A comparison with industry averages provides insights into relative performance and operational efficiency.
- Supplier Relationship Management: Understanding the average balance of payables helps maintain supplier relationships. Companies must balance timely payments to maintain good supplier relations and use credit terms to optimize cash flow.
- Financial Planning and Strategy: APP is a critical input for strategic financial planning and analysis. It helps in cash flow forecasting and understand payment term and policy change impact.
- Liquidity Analysis: It provides a snapshot of the company's short-term liquidity. An extended APP shows that the company conserves cash and suggests liquidity issues.
- Negotiating Power: Knowing the average payment period can empower a company in negotiations with suppliers. Companies with an excellent record of timely payments can negotiate more favorable terms.
- Risk Assessment: For investors and creditors, general information regarding the average payment period is vital to assess a company's risk profile. It shows how well a company handles its short-term financial obligations.
Limitations of Average Payment Period
- Payment Variances: APP is an average measure and can not capture supplier payment period variances. A company can pay some suppliers faster than others.
- Payment Terms Influence: The APP can be influenced by the payment terms negotiated with suppliers. Longer payment terms will naturally extend the APP, which will not show poor liquidity or cash management.
- Industry-Specific Norms: APP can vary significantly across industries, making it less useful for cross-industry comparisons. Each sector has standard payment practices that influence APP.
- Doesn't Show Financial Health: APP doesn't always indicate a company's financial health. A long APP suggests efficient cash management rather than financial distress.
- Historical Data: Average payables period is based on financial modeling data and cannot accurately reflect current or future payment practices or the company's current cash position.
- Manipulation: Companies can manipulate payment timings, especially at period ends, to present a more favorable APP. This can distort the accurate picture of a company's payment practices.
- Doesn't Account for Non-COGS Payments: APP primarily focuses on payments related to the cost of goods sold and does not include other types of payables, such as operating expenses or capital expenditures.
- External Factors: Economic conditions, supplier power, and market dynamics can all influence a company's payment period, which the APP does not account for.
FAQs
1) What is the relationship between APP and Cash Conversion Cycle?
Average payment period is a part of the cash conversion cycle. The cash conversion cycle measures how fast a company turns its inventory into cash. It includes three parts: how long it takes to sell inventory (inventory management), how quickly the company collects payments from customers (receivables days), and how long the company takes to pay its suppliers (average payment period). APP helps extend the cycle by allowing the company to hold onto its cash longer.
2) How is APP related to accounts receivable turnover ratio?
The average payment period and the accounts receivable turnover ratio measure different things, but they relate to how a company manages its cash flow. The accounts receivable turnover ratio measures how quickly a company collects cash from its customers. A higher ratio means faster collection of money. While the average payment period focuses on outgoing cash to suppliers, the accounts receivable turnover ratio focuses on incoming cash from customers.
3) What is days sales outstanding?
Days sales outstanding measures how quickly a company collects customer payments after a sale. A lower DSO indicates the company is collecting cash faster. While the average payment period is about paying out cash to suppliers, DSO shows incoming cash from customers.
4) What is another name for average payment period?
APP is also called “average days payable” or “average payable period."
5) How many days is the average payable period?
There's no one-size-fits-all number because it depends on the company's payment policies, the industry standards, and the terms negotiated with suppliers. It can range from 30 to 90 days, but looking at specific company or industry data to get an accurate figure.
6) What does the average payment period of a firm tell us?
The average payment period of a firm tells us how long, on average, the company takes to pay its bills to suppliers. It shows the company's efficiency in managing its short-term obligations.
7) How do you calculate payables period?
Payables Period = (Total Commercial Transactions/Average Accounts Payable) × 365. This calculation shows the average number of days the company takes to pay its suppliers.
