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The average payment period is a measurement of how long a time it takes on average for a business to pay back its creditors. Calculating this requires dividing the amount of credit purchases by the 365 days in a year, and then dividing this amount into the total accounts payable for the year. Companies use the average payment period to see how efficiently they are paying back their creditors, thus assuring that payments are being made in a prompt manner. Ideally, this period can be reduced as much as possible, although it should always be measured in comparison to the credit terms being offered to the company in question.
Much of the business world runs on credit transactions. Credit is used by many companies as a way of making purchases before they have the actual capital to pay for them. Of course, at some point they will be responsible for paying back all of the other firms who have extended credit to them. If a company can identify shortcomings in their payback of creditors, they can avoid unnecessary complications to their business operations. This is why the average payment period is such an important tool.
As an example of how average payment period is calculated, imagine that a certain company has made a total of $730,000 US Dollars (USD) in credit purchases in a single year. Dividing this amount by the 365 days in a year yields the average credit purchases per day. In this case, that amount comes to $2,000 USD. That is the first half of the equation.
This amount is then divided into the accounts payable the company has amassed in a single year, a total which can be found on a balance sheet. Using the same example, imagine that the company's accounts payable for the year is $60,000 USD. The average payment period is determined by dividing the accounts payable by the average credit purchases per day. In this case, it would be $60,000 USD divided by $2,000 USD, which yields a quotient of 30. Thus, the company takes an average of 30 days to pay back creditors.
It is important to realize that this number is only important in terms of the credit arrangements set up by the company. Specific firms might set up different schedules for when they want to be paid back for credit offered to others. The average payment period should obviously always stay below the time preferred by creditors to receive their payment.