- A company's operating cycle is the length of time
from when the company buys its inventory
until when the company collects the cash
associated with selling that inventory.
The total length of the operating cycle
is the sum of two time periods,
the number of days that elapse
from the purchase of inventory to when it's sold
plus the number of days from the sale of the inventory
until the customer pays in cash.
Walmart, for example,
sells the inventory that it purchases from Toro,
Proctor and Gamble, and its other suppliers
in an average of 42 days.
This number is called
the number of days' sales in inventory
and is computed as follows.
Inventory divided by average daily cost of sales.
And average daily cost of sales
is just the annual cost of sales divided by 365 days.
Using the numbers for Walmart
for the year ending January 31st, 2019,
the number of days' sales in inventory
is computed as follows.
44.269 billion divided by 1.056 billion,
which equals 42 days.
That's an average across all Walmart product lines.
Some items sell faster than that
and some take longer,
but on average, 42 days elapse
from the time Walmart buys something from a supplier
until Walmart sells that thing to you and me.
By comparison, the same computation for Target
gives a number of days' sales in inventory of 65 days.
Walmart runs its inventory through the system
23 days faster than does Target.
Now, let's talk about the length of time
from when a company sells its inventory to a customer
until that customer pays in cash.
This is called the average collection period
and is computed as follows.
Accounts receivable divided by average daily sales.
Because all of Walmart's sales are basically cash sales,
Walmart collects its cash
from a credit card sale almost instantly,
the length of Walmart's operating cycle
is 42 days plus an instant.
42 days from the purchase of the inventory until its sale
and then just an instant from the sale
until the collection of cash.
Let's look at a more interesting average collection period
by examining the numbers for Nike.
The number of days' sales in inventory for Nike is 94 days.
That's the length of time from when Nike purchases
the raw material for the shoes and clothing
to when those materials are turned into athletic apparel
and sold to retail outlets for you and me to buy.
94 days.
Then Nike has to wait for Foot Locker
and Dick's Sporting Goods
and 100 other retail outlets to pay for these goods.
Using the numbers for Nike
for the year ended May 31st, 2018,
the average collection period is computed to be 35 days.
Now, that's an average across all Nike customers.
On average, 35 days elapse
from the time Nike sells something to its retail vendors
until Nike collects the cash from that sale.
94 days from the purchase of raw materials
until the sale of the finished goods
and then an additional 35 days
to collect cash from the customer.
That makes Nike's operating cycle 129 days.
Now, 129 days is 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 my customers pay in a timely fashion.
I can try to gently drive down the time I wait
to collect the money owed me.
And I can measure the results of my efforts
by monitoring the average collection period number.
Also, I can work to manage my inventory better.
I can eliminate bottlenecks
and streamline my production process
to try and reduce the days that I hold inventory,
and I can measure the results of my efforts there
by monitoring the number of days' sales in inventory.