2: Financial Statement and Cash Flow AnalysisThe average collection period, or average age of accounts receivable, is useful in evaluating credit and
collection policies. It measures the average amount of time that elapses from a sale on credit until
the payment becomes usable funds for a company. To compute the measure, we divide the company’s
average daily sales into the accounts receivable balance. As shown in the following equations, in 2016 it
takes GPC, on average, 46.0 days to receive payment from a credit sale:Averagedailysales===
Annualsales
365$12,843
365$35.1 9
Averagecollectionperiod===
Accountsreceivable
Averagedailysales$1,619
$35.1946.0days
The average collection period is meaningful only in relation to the company’s credit terms. If GPC
extends 30-day credit terms to customers, then an average collection period of 46.0 days may indicate a
poorly managed credit or collection department (or both). On the other hand, a longer collection period
could be the result of an intentional relaxation of credit-term enforcement in response to competitive
pressures. If the company had offered customers 45-day credit terms, then the 46.0-day average
collection period would be quite acceptable. Clearly, one would need additional information to evaluate
the effectiveness of the company’s credit and collection policies.
Companies use the average payment period to evaluate their payment performance. This metric
measures the average length of time it takes a company to pay its suppliers. The average payment period
equals the average daily purchases divided into the accounts payable balance. Before calculating average
daily purchases, an analyst may need to estimate the company’s annual purchases, because these are not
reported on a company’s published financial statements. Instead, annual purchases are included in its
cost of goods sold. GPC’s annual purchases in 2016 were estimated at 80% of the cost of goods sold, as
shown in footnote (a) to its income statement (Table 2.2 on page 34).
Using the annual purchase estimate of $6,815, GPC’s average payment period in 2016 indicates that
the company usually takes 90.9 days to pay its bills:Averagedailypurchases===
Annualpurchases
365$6,815
365$18.67
Averagepaymentperiod===
Accountspayable
Averagedailypurchases$1,697
$18.6790.9days
Like the average collection period, the average payment period is meaningful only in light of the
actual credit terms the company’s suppliers offer. If GPC’s suppliers extend, on average, 60-day credit
terms, then the company’s average payment period of 90.9 days suggests that the company is slow in
paying its bills. Paying suppliers 30 days later than the agreed-upon terms could damage the company’s
ability to obtain additional credit, and could raise the cost of any credit that it does obtain.
However, if suppliers grant GPC average credit terms of 90 days, then its 90.9-day average payment
period is very good. Clearly, an analyst would need further information to draw definitive conclusions
about the company’s overall payment policies from the average payment period measurement.
The fixed asset turnover ratio measures the efficiency with which a company uses its fixed assets. The
ratio tells analysts how many dollars of sales the company generates per dollar of investment in fixed
assets. The ratio equals sales divided by net fixed assets:Fixedassetturnover===
Sales
Netfixedassets$12,843
$6,71 0- 91
average collection period
The average amount of time
that elapses from a sale
on credit until the payment
becomes usable funds for
a company. Calculated by
dividing accounts receivable
by average daily sales. Also
called the average age of
accounts receivableaverage payment period
The average length of time
it takes a company to pay
its suppliers. It is calculated
by dividing the company’s
accounts payable balance by
its average daily purchasesfixed asset turnover
A measure of the efficiency
with which a company uses
its fixed assets, calculated by
dividing sales by the number
of dollars of net fixed asset
investment