From the course: Financial Accounting Part 2

Average collection period

From the course: Financial Accounting Part 2

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Average collection period

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- Okay, we've calculated how long our inventory is with us by calculating day sales and 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 of 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 account 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 day 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, day sales and 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 day sales and 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 the 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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