- We need to keep an eye on
how efficiently we are managing our inventory
and how efficiently we are managing our receivables.
These two ratios,
days' sales in inventory and average collection period,
help us keep an eye on these two very important assets.
Okay, we've calculated how long our inventory is 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 credit terms of net 30,
but we can calculate how close
to that net 30, for example, we are
by calculating our average collection period.
Now, there are two steps
in calculating average collection period,
just like there was with inventory.
The first thing we do is calculate
our accounts receivable turnover.
With accounts receivable,
we're going to take our sales number
and we're going to divide that
by average accounts receivable.
And to review, why do we do average accounts receivable?
Remember, sales occur throughout the year,
and we don't want to compare sales throughout the year
with accounts receivable at the end of the year
or at the beginning of the year.
It would be nice if we had an average
accounts receivable balance as well.
And we calculate that by just taking our beginning balance
plus our ending balance, dividing by two,
and then dividing that into our sales revenue.
Let's look at another company
with which we are all familiar, Amazon.
In the case of Amazon, it turns out
their accounts receivable turnover for 2018 was 15.6,
and their average collection period was 23 days.
Now, keep this in mind, this number is an average.
I am certain that for a lot of companies
that are selling products on Amazon,
Amazon requires them to pay upfront in cash
or Amazon takes their cut immediately
when the transaction is processed.
I know that's what I would do.
But some customers are big enough, I'm sure,
that Amazon gives these companies payment terms.
They can take a little longer to pay.
So the average of 23 days
includes a lot of customers who pay immediately
and some customers who take longer to pay.
Ideally, we'd like to be able to divide only credit sales
by average accounts receivable.
But for those of us outside of Amazon,
they don't split their sales between credit and cash sales.
But they would know inside the company,
and you can bet they would be watching
the resulting numbers pretty carefully.
Well, let's talk about the average collection period
in a real-life example
that my brother and I are familiar with.
When we were going to school,
we worked for a small business,
a group of doctors, three very nice doctors.
They were so nice, in fact,
that they had trouble forcing their credit customers to pay.
This was back before insurance companies
would do all that work for 'em.
So the accounts receivable balance back then,
30 years ago, was $300,000.
In today's dollars, that would be about $700,000.
Back then, their average collection period
was about 200 days.
Somebody would come in, the doctor would make 'em better,
and 200 days later they would collect from that.
But these doctors were nice.
What they ended up having to do if they wanted
to get that money, they had to hire somebody
who could be a little more aggressive.
They hired an individual whose job it was
to sit on the phone for 20 hours a week
and just call slow-paying customers.
It turns out they were able to cut that $300,000 in half
in about six months.
Now, what were they able to do with that extra $150,000?
Well, they could pay back loans,
buy additional medical equipment,
take more out of the business personally.
It turns out if money is tied up in receivables,
that constrains what you can do as a business,
just like when money is tied up in inventory.
That constrains what you can do as a business.