From the course: Corporate Financial Statement Analysis
The operating cycle
From the course: Corporate Financial Statement Analysis
The operating cycle
- One of my favorite things in accounting is to take these two ratios, day sales and inventory and average collection period, and add them together. That will tell me a company's operating cycle. - The operating cycle is how long from when we buy the inventory to when we collect the cash associated with selling that inventory. - Walmart, for example, sells the inventory that it purchases from Toro, or Procter & Gamble, or Ben & Jerry's ice cream in an average of 42 days. That's an average across all their product lines. Some items sell faster than that, and some take longer. But on average, 42 days. - Since for Walmart, all sales are basically cash sales. When you use a credit card at Walmart, it's effectively cash to them. Now you owe your credit card company. Walmart gets their cash immediately. They buy the inventory, hold the inventory for 42 days, and then collect the cash immediately from selling that inventory. Let's take a look at Nike. They hold their inventory, on average, for 92 days. That's the length of time from when they purchased the raw materials for the shoes and clothing, to when that material is turned into athletic apparel and sold to the retail outlets of the world for you and me to buy, 92 days. - And then Nike has to wait for their customers to pay them. Now, keep in mind, Nike's typical customer is not you and me, that would be Foot Locker and Dick's Sporting Goods, and a hundred other retail vendors who sell Nike products. - And how long does Nike have to wait to collect the cash? About 36 days on average. Some customers pay sooner than that, and some pay later. But on average, Nike waits 36 days from the sale to the collection of cash from that sale. So, Nike's operating cycle is 128 days. The time from the purchase of raw materials to produce the athletic apparel, to the time they collect the cash from their customers. 128 days. Over four months. Nike has a long operating cycle. - And why is this number important to know? Because now I can start to manage it. I can stay on top of my receivables, the companies that owe me money, to ensure that they pay in a timely fashion. I could try to drive the time I wait to collect the money owed me, down. And I can measure the results of my efforts by monitoring this number. - I can also take efforts to manage my inventory better. I can try to reduce the days that I hold inventory. The results of these ratios provide direction to what aspects of the business to manage. And then the results of these ratios tell me how effective my efforts were. - So, where do we get these numbers for Walmart and for Nike? Which financial statements do I go to, to find out how long a company holds inventory, and how long a company has to wait to collect cash from its customers? - And here you go. Those numbers aren't provided by the companies, you have to compute them. But as you're going to find out in the next couple of modules, if you know where to look, those numbers are hiding in plain sight. - With a little analysis of the financial statements to identify relevant information, and the computation of a couple of ratios relating to the operating cycle, you will soon know more about a company than most of their employees do. Now that is power.
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