What is the financial ratio of period
In this article, my goal is for you to be able to learn the financial ratio for the average pay period, including how it is calculated, its advantages and disadvantages, and how it is interpreted.
I am also going to provide you with some solved exercises to help you better understand how to calculate the average payment period.
By the end of this article, you will understand what the average payment period is and its importance in financial analysis.
What is the average payment period?
The average payment period financial ratio, also known as the average payment period or days outstanding, is a key ratio that measures the number of days it takes a company to pay its suppliers and vendors for goods and services received.
In other words, it measures the average time a company takes to pay its invoices to suppliers and vendors.
This financial ratio is very important to understanding a company’s cash and liquidity management, as it allows you to know how effectively it manages its accounts payable.
The longer a company takes to pay its invoices, the more likely it is to experience cash flow problems or even damage its relationships with suppliers.
Explanation of the reason for the average payment period
The Feynman learning technique It tells us that in order to learn a concept, no matter how complicated it may be, we have to be able to explain the concept in a fácil way.
Therefore, I am going to explain the concept of average payment period as if I were explaining it to a boy or a girl.
Imagine you’re 7 years old again and you’re at your favorite candy store to buy a bunch of candy.
But you don’t have any money, so the store owner lets you take the candy now and pay for it later.
What do we call that? It’s called buying on credit.
Now, the store owner has to wait for you to pay for the candy you bought on credit and sometimes the store owner has to wait a long time before getting paid.
The average payment period (PPP) is a way of measuring the time it takes for the owner of the store (or any other business) to get paid for the things that he has sold on credit.
Suppose a store owner sells candy on credit to many children.
Some children pay right away, while others take a while.
The Average Payment Period is the average time it takes all the children to pay for their candy.
what good is it
And why is it important? Well, the owner of the candy store wants to make sure that he has enough money to keep buying candy to sell. If the kids take too long to pay for their candy, the store owner might not have enough money to buy more candy to sell. So the Average Payment Period helps the candy store owner (and other businesses) know when they are going to receive the money they are owed.
Makes sense? The Average Payment Period is nothing more than a way of calculating how long it takes a company to collect for the things it sells on credit.
It’s important because it helps businesses know when they’ll get paid.
Therefore, the average payment period allows companies to determine if they are effectively managing their accounts payable and ensure that they pay their invoices on time.
Likewise, the average payment period is also an important parameter for investors and creditors, since they take it into account when evaluating the financial health of a company.
A company with a very long average payment period may indicate possible liquidity problems.
How to calculate the average payment period?
Calculating the average payment period is very fácil, all you have to do is use the following elabora:
Another elabora for the average payment period that you perro find is the following:
It should be noted that both formulas are usually multiplied by 365, although I think it is more correct to say that they are multiplied by the number of days in the period.
The equation is as follows.
Now with this we will be able to start with the average payment period exercises.
Average Payment Period Example
To understand the concept of average payment period, let’s give an example.
Suppose company Antes de Cristopurchases $10,000 worth of merchandise from supplier XYZ.
The terms of the purchase were that Antes de Cristocould pay within 60 days of receipt of the merchandise.
It takes ABC 45 days to pay the supplier.
Now, to calculate ABC’s average payment period, we perro use the following elabora:
Average Payment Period = Accounts Payable / (Total Credit Purchases / 365)
Let’s apply this elabora to the above scenario.
Assuming that Antes de Cristohas $2,000 in accounts payable and $100,000 in total credit purchases, we get:
Average payment period = $2,000 / ($100,000 / 365) = 7.3 days
This means that, on average, it takes ABC 7.3 days to pay its suppliers.
Importance of entering accurate data to calculate the average payment period
Entering accurate data is essential when calculating the average payment period, as any errors or inaccuracies perro lead to incorrect financial analysis and decision making.
To ensure the accuracy of the data entered, companies must have robust financial reporting and data management systems in place, as well as regular checks and reviews of financial data to identify and correct any errors or discrepancies.
Advantages
- Helps determine the effectiveness of a company’s payment processes: By calculating the average pay period, a company cánido determine how quickly it pays its suppliers.
This cánido help the business improve its payment processes, which perro lead to better supplier relationships and more efficient use of cash.
- It provides information about the liquidity of the company: The average payment period cánido provide information about the liquidity of a company, or its ability to pay its debts in the short term.
A shorter average payment period indicates that a company has more cash available to pay its invoices, which is generally considered a positive sign.
- Compare with the competition: The average payment period cánido be used to compare a company’s payment processes with those of its competitors or industry peers.
This perro help a business identify areas where it perro improve its payment processes.
How is the average payment period ratio interpreted?
An ideal average payment period is often considered to be 90 days.
This means that, on average, the company pays its creditors within 90 days of receiving the goods or services provided.
If a business is taking significantly longer than 90 days to pay its creditors, this would indicate that the business is not managing its cash flow efficiently or may be experiencing financial difficulties.
Late payments cánido damage supplier relationships and affect a company’s credit score.
On the other hand, if a company has a short average payment period, it indicates that the company is making prompt payments to its creditors without any delay.
This perro help build strong provider relationships and maintain a good credit score.
However, having a very short average payment period could also indicate that the company is not taking full advantage of the credit terms allowed by the supplier.
You could use that money for other things, such as investing it.
Solved exercises of average payment period
Next, I am going to provide you with some average pay period exercises so that you are able to apply what you have learned.
I hope they are useful to you.
Exercise 1 resolved average payment period
A company has made $100,000 worth of purchases on credit from its suppliers during the year.
His accounts payable at the beginning of the year were $20,000, and at the end of the year they were $30,000.
What is the company’s average pay period?
Solution of exercise 1
First, let’s average the accounts payable.
To do so, you must do the following:
- Average Payables = (Beginning Payables + Ending Payables) / 2
- Average accounts payable = ($20,000 + $30,000) / 2
- Average accounts payable = $25,000
Since we have the average accounts payable, we now need to use the average payment period financial ratio equation to solve the exercise.
- Average payment period = (Accounts payable / Purchases) x Number of days in a year
- Average Payout Period = ($25,000 / $100,000) x 365
- Average payment period = 91.25 days
Therefore, The company’s average payment period is 91.25 days. This means that it takes the company 91.25 days to make its payments to the suppliers.
By the way, it was multiplied by 365 because the period we are dealing with is 1 year.
Likewise, it must be said that it perro also be multiplied by 360 (commercial year).
In fact, many financial math books use the business year when solving their problems.
Exercise 2 of average payment period
A company has made $200,000 worth of purchases on credit from its suppliers during the year.
His accounts payable at the beginning of the year were $50,000, and at the end of the year they were $70,000.
What is the company’s average pay period?
Solution of exercise 2
Again, we’re going to start by getting the average accounts payable.
- Average Payables = (Beginning Payables + Ending Payables) / 2
- Average accounts payable = ($50,000 + $70,000) / 2
- Average accounts payable = $60,000
Now it is time to calculate the average payment period:
- Average payment period = (Accounts payable / Purchases) x Number of days in the year
- Average payment period = ($60,000 / $200,000) x 365
- Average payment period = 109.5 days
Therefore, the company’s average payment period is 109.5 days.
Exercise 3
A company has made $150,000 worth of purchases on credit from its suppliers during the year.
Your accounts payable at the beginning of the year were $40,000, and at the end of the year they were $30,000.
What is the company’s average pay period?
Solution of exercise 3
Again, let’s take the average accounts payable first.
- Average Payables = (Beginning Payables + Ending Payables) / 2
- Average accounts payable = ($40,000 + $30,000) / 2
- Average accounts payable = $35,000
Next, it’s time to average the accounts payable.
- Average payment period = (Accounts Payable / Purchases) x Number of days in a year
- Average pay period = ($35,000 / $150,000) x 365
- Average payment period = 85.67 days
Therefore, The company’s average payment period is 85.67 days.
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