Average payment period means the average period taken by the company in making payments to its creditors. It is computed by dividing the number of working days in a year by creditors turnover ratio. Some other formulas for its computation are give below:

Formula:

This ratio may be computed in a number of ways:

average-payment-period-formula

Any of the above formulas may be used to compute average payment period. If credit purchases are unknown, the total purchases may be used.

Example:

Metro trading company makes most of its purchases on credit. The extracted data for the year 2012 is given below:

Total purchases $ 600,000
Cash purchases 150,000
Purchases returns 30,000
Accounts payable at the start of the year  65,000
Accounts payable at the end of the year 40,000
Notes payable at the start of the year 20,000
Notes payable at the end of the year  15,000

Required: Calculate average payment period from the above data.

Solution:

When complete information about credit purchases and opening and closing balances of accounts payable is given, the proper method to compute average payment period is to compute accounts payable turnover ratio first and then divide the number of working days in a year by accounts payable turnover ratio.

= $420,000* / $70,000**

= 6 times

Average payment period = 360 days /6 times

60 days

The average payment period of Metro trading company is 60 days. It means, on average, the company takes 60 days to pay its creditors.

*Computation of net credit purchases:

Total gross purchases $ 600,000
Less purchases returns 30,000
———–
Net purchases 570,000
Less cash purchases 150,000
———–
Net credit purchases 420,000
———–

**Computation of average accounts payable:

[(A/R opening +  N/R opening) + (A/R closing + N/R closing)] / 2

[($65,000 + $20,000) + ($40,000 + $15,000)] / 2

[$85,000 + $55,000] / 2

$140,000 /2

$70,000

Significance and interpretation:

A shorter payment period indicates prompt payments to creditors. Like accounts payable turnover ratio, average payment period also indicates the creditworthiness of the company. But a very short payment period may be an indication that the company is not taking full advantage of the credit terms allowed by suppliers.

Managers try to make payments promptly to avail the discount offered by suppliers. Where the discount is available for early payment, the amount of discount should be compared with the benefit of the length of the credit period allowed by suppliers.