Learn how to compute days' sales in inventory.
- Okay, we've calculated how long our inventory's with us by calculating days' sales in inventory. We can do the same thing with receivables. If we sell that inventory on credit, how long until we can expect to get the cash? Now, we may have terms of net 30, but we can calculate how close to that net-30, for example, we are getting, by calculating our average collection period. There are two steps in calculating the average collection period, just like with inventory. The first thing we do is to calculate our accounts receivable turnover. We take our sales revenue this time. Remember, with inventory we took cost to goods sold. With accounts receivable, we'll take our sales number, and we divide that by average accounts receivable. And to review, why do we do average accounts receivable? Remember, sales occur throughout the year. We don't want to compare sales throughout the year with accounts receivable at the end or accounts receivable at the beginning of the year. It'd be nice if we had an average accounts receivable balance as well. And we calculate that average just by taking our beginning balance plus our ending balance, dividing by two and then dividing that into our sales revenue. As an example, let's take a look at Nike. It turns out that their accounts receivable turnover in 2018 was 10. Now, what do we do with this number? Well, as we did with inventory, we simply divide it into 365 to get our average collection period. In the case of Nike, it takes them 36 days on average to collect their receivables. Now, keep in mind this is an average. Now, if their terms are net 30, and it's taking 36 days, we would have questions about that. We would ask the individual in charge of their credit policy, "What's the deal here?" What we would find is that they are charging interest for people who take longer than 30 days. So, Nike collects their receivables, on average, in 36 days. Some people take a little longer than that, some people take shorter than that. But on average, it's 36 days. Now, let's compute Nike's days' sales in inventory. We first compute their inventory turnover, which is four, and we divide this into 365 days. The result is that Nike owns their inventory for about 91 days. Now, add these two numbers together, days' sales in inventory and average collection period, and you get the company's operating cycle. In the case of Nike, their operating cycle is 127 days. That is, from when they buy the materials to construct the clothing and other products they sell until they collect the cash from selling those products, the time is 127 days, just over four months. Now, 127 days, good or bad? Well, it depends. How are others in the same industry doing? Let's take a look at Under Armour, which is in the same market. Their days' sales in inventory is 138 days. Their average collection period is 45 days. The result is an operating cycle of 183 days. That is almost two months longer than Nike's operating cycle. Two months longer to wait and get to cash. That is a long time. But wait. We're not done yet. We have computed how long it takes to turn inventory into cash. Now, how long does it take until the company has to pay for the inventory that it purchased? We need to keep an eye on how efficiently we are managing our inventory. How efficiently we are managing our receivables as well. Next we're going to calculate when do we have to pay?
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