- Now let's look at efficiency ratios.
We have two efficiency ratios we're going to drill down on.
Keep in mind there are others.
But these two are perhaps the two
that deserve the most attention.
The first one is number of days' sales in inventory.
And the second is average collection period.
As a reminder number of days' sales in inventory tells me
how long on average does my inventory stay with me
until it's sold.
The average collection period tells me, on average,
how long from when I sell something on credit
until I collect the cash.
These two together, days' sales in inventory
and average collection period
indicate what we call the company's operating cycle.
So let's look first at inventory turnover.
We buy inventory and the question is,
how long until we sell that inventory?
Can we calculate on average
how long our inventory sits in our store for example?
Well, we have a measure for that.
It's called days' sales in inventory
and the first step in calculating days' sales in inventory
is we take a measure called our inventory turnover.
That is how often we turn our inventory over every year.
Think of it this way.
I have inventory, how long until I sell it all, buy more,
sell it all, buy more, sell it all,
how many times do I do that in a year?
There's an easy way to calculate that.
And that is to take our cost of goods sold
and divide that by our average inventory for the year.
Now, why use average inventory for the year?
Well, cost of goods sold occurs throughout the year
and our inventory comes and goes
throughout the year as well.
So to match a cost of goods sold throughout the year measure
we approximate how much inventory do we have
on average throughout the year.
We'll take our beginning inventory balance,
add our ending inventory balance,
divide it by two to get an approximation
of how much inventory did we have
on average throughout the year.
So to calculate inventory turnover,
cost of goods sold is divided by average inventory.
Let's look at Walmart.
Walmart in 2018 turned their inventory over 8.75 times.
Contrast that with Target in the same industry.
Target turned their inventory over 5.9 times
during the same period.
Now we can take that inventory number measure
and make one more step
and all of a sudden it makes a great deal of sense.
If I take that inventory turnover number
and simply divide it into 365,
then I can figure our how long on average
does my inventory sit in the business, how many days?
In this case of Walmart with an inventory turnover of 8.75,
if we divide that 8.75 into 365 days, on average,
Walmart has it's inventory in its stores 42 days.
That's an average across all their product lines,
car tires, lettuce in the produce section,
clothing, toys, you name it.
Now inside the company they would have information
to compute days' sales in inventory by each product line,
but they don't provide that level of detail
to those outside the company,
but you can be sure
that those inside the company are doing these computations.
Now compare Walmart's number on the other hand to Target.
If we take their inventory turnover of 5.9
and divide that into 365 days, Target on average,
has it's inventory sit there for almost 62 days.
Walmart 42 days on average, Target 62 days on average,
there's a being difference there.
Now, it's an important measure
because it turns out if your money is tied up in inventory
you're constrained as to what else you can do.
Now for I were working for Target,
I now would have a question that I would want the answer to.
Why is Walmart's days' in inventory so much lower than ours?
And there are individuals I could find
that would have the answer to that question.