Average payment period
The average payment period (also called Days Payable Outstanding) shows the number of days the average number of purchases remains unpaid. In other words, it shows the average number of days the company has taken to pay its goods suppliers. According to the credit period allowed by the suppliers, it will indicate whether or not the company paid the suppliers on time. A low ratio can mean the firm's sound liquidity position, resulting in the company being able to take advantage of the supplier's cash discounts. A higher ratio could result in[1]:
- fewer discount facilities
- higher prices paid for the goods.
It is very important to compare the ratio with the ratio of different other companies in the same industry and to study the trend of this ratio in the company itself[2].
It needs to be as close as possible to the credit terms provided by the suppliers (usually 30 days), but some companies push out payables unethically as higher numbers tie up less of their money as it attracts more cash from their suppliers. If a company is genuinely cash-starved at a certain point in time, the appropriate course of action is to contact your suppliers to explain the situation and request for more time[3].
Average Payment Period Formula
The formula of the Average Payment Period is presented as[4]:
Example of The Payment Period
If purchases for the year are £90,000 and trade creditors are £20,000:
Again this should be compared with previous years, with similar businesses, and the length of time that creditors allow for payment. Note that a business may deliberately delay payment of creditors for as long as reasonably possible. Large companies, in particular, may do this as they have stronger bargaining power than their smaller creditors. If the period has dramatically increased, it may be that the business is having difficulty in paying its bills. However, a large figure for creditors may just be due to an increase in purchases just before the date of the balance sheet, and this may have been in anticipation of increased sales, or to buy in before prices are increased."[5]
Advantages of Average payment period
A low average payment period can provide a variety of advantages to a business. These advantages include:
- Improved cash flow, as suppliers are paid faster, allowing the business to take advantage of any discounts they may offer for early payment.
- Reduced borrowing costs, as the company is able to pay suppliers on time and therefore needs to borrow less money to cover short-term financial needs.
- Improved relationships with suppliers, as the company is seen as a reliable partner and is more likely to be given favourable terms.
- Reduced risk of bad debts, as the company is able to pay off any debts before they become overdue.
- Increased profits, as the company can pay suppliers on time and in full, resulting in less money being spent on interest payments and other debt-related costs.
Limitations of Average payment period
The average payment period (also called Days Payable Outstanding) shows the number of days the average number of purchases remains unpaid, indicating the average time taken by the company to pay its suppliers. However, this metric has several limitations:
- It is an average measure and may not reflect the actual situation of the company. It may be distorted if there are few large payments or if the payments are made in batches.
- It does not take into account the credit period allowed by the suppliers, so it is not possible to tell if the company paid the suppliers on time.
- It does not consider the impact of cash discounts, so it is not possible to know if the company was able to take advantage of them.
- It does not consider the company’s liquidity position, so it is not possible to tell if the company is in a sound financial position.
- It does not take into account payment terms or any other factors that could affect the payment period.
One way to measure the average payment period is to look at other approaches related to it. These approaches include:
- Calculating the average collection period: This ratio measures the average number of days it takes a company to collect on its accounts receivables. A decrease in the average collection period would mean that the company is collecting payments more quickly and efficiently.
- Estimating the average age of inventory: This ratio measures the average number of days the inventory has been held by the company. A decrease in this figure would mean that the company is selling its inventory faster and making more efficient use of its resources.
- Calculating the cash conversion cycle: This ratio measures the number of days it takes for a company to convert cash from its raw materials purchases to cash from the sale of its finished goods. A decrease in this figure would mean that the company is able to convert its resources into cash more quickly and efficiently.
In summary, a company's average payment period can be measured in several ways, such as by calculating the average collection period, estimating the average age of inventory and calculating the cash conversion cycle. By understanding these ratios, a company can better manage its cash flow and liquidity position.
| Average payment period — recommended articles |
| Payables turnover — Days payable — Acid-test ratio — Average collection period — Degree of financial leverage — Asset coverage ratio — Activity ratios — Burn Rate — Contribution margin ratio |
References
- Allen J. E., (2004)., Assisted Living Administration: The Knowledge Base, Second Edition, Springer Publishing Company, United States of America
- Banerjee B., (2012)., Financial Policy and Management Accounting, PHI Learning Pvt. Ltd., India
- Kay D., Baker J., (2007)., Solicitors' Accounts, 2007-2008, Oxford University Press, Great Britain
- Shukla M. C., Grewal T. S., Gupta S. C., (2017)., Advanced Accounts Volume-II, 19th Edition, Tom 2, S. Chand Publishing, India
- Zieltow J., Seidner A. G., (2007)., Cash & Investment Management for Nonprofit Organizations, John Wiley & Sons, United States of America
Footnotes
Author: Aleksandra Walawska
