Also known as an important solvency ratio, the average payment period (APP) assesses how much time it takes for a business to pay its vendors, in the case of purchases made on credit. Many times, when a business makes an important purchase, credit arrangements are made beforehand. These arrangements might give the buyer a specific amount of time to pay for the goods.
Defining the Average Payment Period
Frequently, when the payment is operated quickly, the buyer might take advantage of specific discounts, which would diminish the overall price of the purchase. For instance, in the case of a 10/30 credit term, as a buyer, you might benefit from a 10 percent discount, granted that the balance is paid within 30 days. In general, the standard credit term is 0/90 – which facilitates payment in 90 days, yet no discounts whatsoever.
The reason why this ratio is widely used is that it provides insight into a firm’s cash flow and creditworthiness. Basically, this means that, in some cases, it could highlight existing concerns. For instance, it might offer answers to question like: is the company capable of meeting its financial obligations or not? Can it use its cash flow in an efficient manner or not? Hence, analysts, investors, and creditors will definitely find this information vital.
Before you proceed with the actual calculation process, you must locate the accounts payable information, which is present on the balance sheet – beneath the current liabilities section. As a rule of thumb, the average payment period is determined by utilizing a year’s worth information. Nevertheless, it could be really useful to do an evaluation on a quarterly basis, or over a specific timeframe.
What is the Formula of the Average Payment Period?
First of all, you have to establish the average accounts payable. You do that by dividing the sum of beginning and ending accounts payable by two, as you can see in this equation.
A management usually uses this ratio for establishing whether paying off credit balances faster and receiving discounts might actually benefit the company or not. Evidently, this information is relative to the company’s needs and the industry. But it is crystal clear that the average payment period is a critical factor, specifically when it comes to assessing the firm’s cash flow management. Thus, it is highly recommended to analyze other companies’ metrics in your specific industry.
Evidently, analysts and investors find this ratio useful – the goal is to determine whether the firm is financially capable of making the payments. It isn’t of utmost importance if it accomplishes this at the fastest rate possible.
To conclude, the payment period accounts for a sensor that points how well a company can utilize its cash flow to cover short-term needs. Any changes that could occur to this number have to be evaluated in detail to determine the immediate effects on the cash flow.