Average Payment Period

Average payment period (APP) is one of the activity ratios which measures the relationship between accounts payable and average purchases per day. Activity ratios help businesses to measure how efficiently various accounts are converted into sales or cash. Other activity ratios include average collection period, total asset turnover and inventory turnover analysis.

APP calculates how efficiently accounts payable are settled. It indicates, on average, how many days does it take to pay off accounts payable. APP is also referred to as the average age of accounts payable or the accounts payable turnover ratio.

The formula to calculate the APP is as follows:

APP = Accounts payable/Average purchases per day

The figure for accounts payable is obtained from the balance sheet and the figure for purchases is indirectly obtained from the income statement. Here the difficulty of calculating APP is highlighted. A figure for purchases is usually not available. Therefore, purchases are usually estimated as a percentage of cost of goods sold, which is in turn obtained from the income statement.

Purchases must be adjusted for credit purchases. This is done by deducting cash purchases. Further, credit purchases must be divided by the number of days per year to finally obtain average purchases per day.

Average credit purchases per day = Credit purchases/365

Example calculation


Assume First Parsons Company has accounts payable of $840,000 and credit purchases of $5,300,000. First Parsons Company was granted credit terms of 30 days by all its creditors. Assume there are 365 days year.

The average payment period of First Parsons Company is calculated as follows:

Firstly, we need to calculate the average credit purchases per day.

Average credit purchases per day = Credit purchases/365

= $5,300,000/365

= $14,520.55

Now, we are ready to calculate APP.

= $840,000/$14,520.55

=57.85 days

= 58 days

The APP of the First Parsons Company is 58 days. It takes on average 58 days to settle the accounts payable. However, the credit terms granted by creditors to First Parsons Company is 30 days. This means that company’s creditors require accounts to be settled within 30 days.

In light of this information, it is evident that payment of accounts payable is inadequately managed. If First Parsons Company will not attend to this issue in a timely manner, the current payment practices may lead to a number of harmful effects. Such harmful effects may include the inability to buy on credit from current suppliers, damage to the credibility of the business and a significantly deteriorating credit rating. This will be very harmful for the firm due to the further limitations it will impose on obtaining credit.

Things to note about this ratio


The average payment period analysis is only relevant when compared to credit terms granted to the business.

APP allows businesses to gain a better understanding of the cash outflows to be anticipated. Understanding of cash outflows is vital for successful operation of the business.

Average payment period analysis also identifies trends in the payment of the accounts payable. This can bring to management’s attention important variables that must be investigated to ensure successful operation of the business. For example, if the APP of the business increased from 30 to 68 days over 1 year while credit terms extended to the business remained the same at 30 days, a further investigation will be required to understand such a large increase in this ratio.

Further, to obtain a better understanding, one should compare the APP ratio to industry averages, to the ratio of leading firms in the industry and to the firm’s own historical results.

Blogbschool.com is powered by www.firmsconsulting.com. Firmsconsulting is a training company that finds and nurtures tomorrow’s leaders in business, government and academia via bespoke online training to develop one’s executive presence, critical thinking abilities, high performance skill-set, and strategy, operations and implementation capabilities. Learn more at www.firmsconsulting.com.

Sign up to receive a 3-part FREE strategy video training series here.

Average Collection Period

The average collection period is one of the activity ratios which measures the relationship between accounts receivable and average credit sales per day. Activity ratios help businesses to measure how efficiently various accounts are converted into sales or cash. Other activity ratios include average payment period, total asset turnover and inventory turnover analysis.

It calculates how efficiently accounts receivable are collected. It indicates the quality of debtors of the business (how promptly debtors pay their bills as they come due). It is also referred to as the average age of accounts receivable, debtors collection period ratio or a collection ratio.

The formula to calculate the average collection period ratio is as follows:

Average Collection Period = Accounts receivable/Average sales per day

The figure for accounts receivable is obtained from the balance sheet and the figure for sales is obtained from the income statement. Sales must be further adjusted to credit sales, by excluding cash sales. Further, credit sales must be divided by the number of days per year to finally obtain average sales per day (average credit sales per day).

Average sales per day = Credit sales/365

Example calculation


Assume Heroic Company has accounts receivable of $750,000 and credit sales of $4,050,000. Heroic Company has credit terms of 30 days. Assume 365 days year.

The average collection period of Heroic Company is calculated as follows:

Average sales per day = Credit sales/365

= $4,050,000/365

= $11,095.89

Average collection period = $750,000/$11,095.89=67.6 days = 68 days.

It takes on average 68 days to collect the accounts receivable. However, the credit terms of Heroic Company is 30 days. This means that company’s customers have 30 days to settle their accounts.

In light of this information, it is evident that collection of accounts receivable and/or process of granting the credit to customers is inadequately managed. The performance and processes of credit and collection departments should be investigated to draw further conclusions.

Things to note about this ratio


Results are only relevant when compared to a company’s credit terms.

The average collection period ratio therefore allows business to gain a better understanding of the cash inflows to be anticipated. Understanding of cash inflows are vital for successful operation of the business.

It also allows to identify trends in the collection of the accounts receivable. This can bring to management’s attention important variables that must be investigated to ensure successful operation of the business. For example, if the average collection period of the business increased from 30 to 68 days over 1 year, a further investigation will be required to understand such a large increase in this ratio.

Furthermore, to obtain a better understanding, one should compare the average collection period ratio to industry averages, to the ratio of leading firms in the industry and to the firms own historical results.

 

Inventory Turnover Analysis

Inventory turnover analysis measure the liquidity of a firm’s inventory. It measures how many times the company turns over (sells, uses or replaces) its inventory during a period, such as the financial period.

It is calculated by dividing cost of goods sold by inventory. The formula is as follows.

Inventory Turnover = Cost of goods sold/Inventory

The results can be conveniently used to calculate the average age of inventory (also called average number of days sales in inventory or inventory turnover days) with the following formula:

Average age of inventory = 365/Inventory Turnover

Example of inventory turnover analysis


Assume Gold Co. has cost of goods sold of $1,850,000 and inventory of $680,000. Assume there are 365 days in the year. The inventory turnover analysis and average age of inventory analysis for the Gold Company is conducted as follows:

Inventory turnover analysis:

$1,850,000/$680,000=2.7

This indicates the business turns over its inventory 2.7 times per year.

Average age of inventory:

365/2.7=135.2

Things to note about inventory turnover analysis


The results are only meaningful when used in comparison. It can be compared to industry averages, to the firm’s past inventory ratios and to ratios of competitors.

Industry averages differ significantly between industries for this ratio. This ratio is positive (higher than zero) as long as the firm has any inventory. Generally, a high ratio is considered to be a good indicator.

However, the norm would differ significantly between industries. If the ratio is too high when compared to the norm within the industry, it may mean the company keeps too little inventory and, therefore, may lose some sales. On the other hand, a low ratio may indicate excess inventory and inferior sales. Excess inventory is usually considered to be undesirable as inventory is an investment without return, holding inventory implies costs and prices of goods to be sold may start decreasing.

Blogbschool.com is powered by www.firmsconsulting.com. Firmsconsulting is a training company that finds and nurtures tomorrow’s leaders in business, government and academia via bespoke online training to develop one’s executive presence, critical thinking abilities, high performance skill-set, and strategy, operations and implementation capabilities. Learn more at www.firmsconsulting.com.

Sign up to receive a 3-part FREE strategy video training series here.

Earnings Available for Common Stockholders

In summary, to calculate earnings available for common stockholders, we need to subtract cost of goods sold, operating expenses, and interest, tax and preferred stock dividends from sales revenue.

To calculate these earnings available, we need to understand the format of the income statement.

Income Statement Format


Sales revenue

LESS: Cost of goods sold

= Gross profit

LESS: Operating expenses

= EBIT (earnings before interest and tax/operating profit)

LESS: Interest

= Net profit before tax

LESS: Taxes

= Net profit after tax

LESS: Preferred stock dividends

= Earnings available for common stockholders

Therefore, to calculate earnings available for common stockholders, all we need to do is to subtract cost of goods sold, operating expenses, interest, tax and preferred stock dividends from the sale revenue.

Knowing the the earnings available for common stockholders is very important. Among other uses, it allows us to do the following:

1 – It allows you to calculate EPS:

Calculating EPS allows us to understand how much dollars were earned on each outstanding share of common stock.

2 – It also allows you to calculate the net profit margin ratio:

Net Profit Margin ratio = Earnings Available for Common Stockholders / Sales.

Net profit margin ratio measures how much of each sales dollar remains after all costs are deducted. In other words it measures how successful the firm is in terms of its earnings on sales.

Blogbschool.com is powered by www.firmsconsulting.com. Firmsconsulting is a training company that finds and nurtures tomorrow’s leaders in business, government and academia via bespoke online training to develop one’s executive presence, critical thinking abilities, high performance skill-set, and strategy, operations and implementation capabilities. Learn more at www.firmsconsulting.com.

Sign up to receive a 3-part FREE strategy video training series here.

Calculating net profit after tax

In summary, to calculate net profit after tax, we need to subtract cost of goods sold, operating expenses, interest and tax from the sales revenue.

To make this calculation, we need to understand the format of the income statement.

Income Statement Format


Sales revenue

LESS: Cost of goods sold

= Gross profit

LESS: Operating expenses

= EBIT (earnings before interest and tax/operating profit)

LESS: Interest

= Net profit before tax

LESS: Taxes

= Net profit after tax

LESS: Preferred stock dividends

= Earnings available for common stockholders

Therefore, to calculate net profit after tax, all we need to do is to subtract cost of goods sold, operating expenses, taxes and interest from sales revenue.

Blogbschool.com is powered by www.firmsconsulting.com. Firmsconsulting is a training company that finds and nurtures tomorrow’s leaders in business, government and academia via bespoke online training to develop one’s executive presence, critical thinking abilities, high performance skill-set, and strategy, operations and implementation capabilities. Learn more at www.firmsconsulting.com.

Sign up to receive a 3-part FREE strategy video training series here.

Calculating net profit before tax

In summary, to calculate net profit before tax, we need to subtract cost of goods sold, operating expenses and interest from sales revenue. We need to understand the format of the income statement.

Income Statement Format


Sales revenue

LESS: Cost of goods sold

= Gross profit

LESS: Operating expenses

= EBIT (earnings before interest and tax/operating profit)

LESS: Interest

= Net profit before tax

LESS: Taxes

= Net profit after tax

LESS: Preferred stock dividends

= Earnings available for common stockholders

Therefore, to calculate net profit before tax, all we need to do is to subtract cost of goods sold, operating expenses and interest from sales revenue.

Blogbschool.com is powered by www.firmsconsulting.com. Firmsconsulting is a training company that finds and nurtures tomorrow’s leaders in business, government and academia via bespoke online training to develop one’s executive presence, critical thinking abilities, high performance skill-set, and strategy, operations and implementation capabilities. Learn more at www.firmsconsulting.com.

Sign up to receive a 3-part FREE strategy video training series here.

How to calculate EBIT (Operating Profit)?

In summary, to calculate EBIT, we need to subtract the costs of goods sold and operating expenses from sales revenue.

To determine EBIT (operating profit), we firstly need to understand the format of the income statement.

Income Statement Format


Sales revenue

LESS: Cost of goods sold

= Gross profit

LESS: Operating expenses

= EBIT (earnings before interest and tax/operating profit)

LESS: Interest

= Net profit before tax

LESS: Taxes

= Net profit after tax

LESS: Preferred stock dividends

= Earnings available for common stockholders

Therefore, to determine EBIT, all we need to do is to subtract the cost of goods sold and operating expenses from sales revenue.

Other uses for EBIT


1 – Calculate the Operating Profit Margin Ratio = Operating profit (EBIT) / Sales The operating profit margin measures how much of each sales dollar remains after all costs except for interest, tax and preferred dividends are deducted. In other words it measures how efficient the business manages its operations or how efficiently the firm manages its income statement (keeping a healthy balance between sales and costs).

2 – Calculate the Times Interest Earned Ratio = EBIT/Interest

The times interest earned ratio (Interest Coverage Ratio) measures the ability of the enterprise to meet its financial obligations (interest payments on debt that come due).

Blogbschool.com is powered by www.firmsconsulting.com. Firmsconsulting is a training company that finds and nurtures tomorrow’s leaders in business, government and academia via bespoke online training to develop one’s executive presence, critical thinking abilities, high performance skill-set, and strategy, operations and implementation capabilities. Learn more at www.firmsconsulting.com.

Sign up to receive a 3-part FREE strategy video training series here.

Calculating gross profit

Calculating gross profit is simple and straightforward. In summary, we need to subtract cost of goods sold from the sales revenue.

Whilst making this calculation, we need to have a good understanding of the format of the Income Statement, as shown below. More details can be found in the format of the income statement section.

Income Statement Format


Sales revenue

 

LESS: Cost of goods sold

= Gross profit

LESS: Operating expenses

= EBIT (earnings before interest and tax/operating profit)

LESS: Interest

= Net profit before tax

LESS: Taxes

= Net profit after tax

LESS: Preferred stock dividends

= Earnings available for common stockholders

Therefore, all we need to do is to subtract cost of goods sold from the sale revenue. But how do we find the cost of goods sold? To calculate the cost of goods sold, we need to take the following steps:

Cost of goods sold =

Opening inventory

ADD: Purchases

LESS: Closing inventory

Gross profit allows us, among other things, to calculate the Gross Profit Margin Ratio , which is:

Gross Profit Margin = Gross Profit / Sales GPMR measures how much of each sales dollar is remaining after costs of goods are deducted. In other words it measures the relative cost of goods sold.

Income Statement Format

Familiarity with the income statement format is important for anyone who wants to succeed in business studies and a business career. You need to be familiar with the format to the point of being able to write down the format from memory.

The income statement, which is also referred to as profit and loss statement (P&L), is one of the most important financial statements. Other important financial statements include the balance sheet, cash flow statement and statement of changes in equity.

A good way to compare the income statement, balance sheet (financial position statement) and cash-flow statement is to think of a river leading to a dam. The income statement and a cash-flow statement record the movement of money over a specific period of time. It is similar to recording the volume flowing down a river over specific period. The balance sheet (financial position statement) is the dam. Everything collects there.

The income statement calculates if the business generated a profit or incurred loss during a specified financial period. In other words, it shows profitability of the organization over a certain period.

If profit was generated during then the bottom line of the statement will be a net profit after taxes, which is also called the net income. The general format is presented below.

General income statement format


Sales revenue

LESS: Cost of goods sold*

= Gross profit

LESS: Operating expenses

= EBIT (earnings before interest and tax/operating profit)

LESS: Interest

= Net profit before tax

LESS: Taxes

= Net profit after tax

LESS: Preferred stock dividends

= Earnings available for common stockholders

To calculate Cost of goods sold, one needs to follow the steps:

Opening inventory

Add: Purchases

Less: Closing inventory

= Cost of goods sold