Operating ratio

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.