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111.3 days

So, the inventory period is about 111 days. On average, in other words, inventory sat for about 111 days before it was sold.3

Similarly, receivables averaged $1.8 million, and sales were $11.5 million. Assuming that all sales were credit sales, the receivables turnover is:4

Credit sales

Receivables turnover

Average accounts receivable $11.5 million

6.4 times 1.8 million

If we turn over our receivables 6.4 times, then the receivables period is:

365 days

Receivables period

Receivables turnover

The receivables period is also called the days' sales in receivables or the average collection period. Whatever it is called, it tells us that our customers took an average of 57 days to pay.

The operating cycle is the sum of the inventory and receivables periods:

Operating cycle = Inventory period + Accounts receivable period = 111 days + 57 days = 168 days

This tells us that, on average, 168 days elapse between the time we acquire inventory and, having sold it, collect for the sale.

The Cash Cycle We now need the payables period. From the information given earlier, we know that average payables were $875,000 and cost of goods sold was $8.2 million. Our payables turnover is:

Cost of goods sold

Payables turnover -

Average payables $8.2 million

$.875 million

The payables period is:

365 days

9.4 times

Payables period

Payables turnover

3This measure is conceptually identical to the days' sales in inventory figure we discussed in Chapter 3.

4If fewer than 100 percent of our sales were credit sales, then we would just need a little more information, namely, credit sales for the year. See Chapter 3 for more discussion of this measure.

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

VII. Short-Term Financial Planning and Management

19. Short-Term Finance and Planning

© The McGraw-Hill Companies, 2002

CHAPTER 19 Short-Term Finance and Planning

Thus, we took an average of 39 days to pay our bills.

Finally, the cash cycle is the difference between the operating cycle and the payables period:

Cash cycle = Operating cycle - Accounts payable period = 168 days - 39 days = 129 days

So, on average, there is a 129-day delay between the time we pay for merchandise and the time we collect on the sale.

The Operating and Cash Cycles

You have collected the following information for the Slowpay Company.

Item

Beginning

Ending

Inventory

$5,000

$7,000

Accounts receivable

1,600

2,400

Accounts payable

2,700

4,800

Credit sales for the year just ended were $50,000, and cost of goods sold was $30,000. How long does it take Slowpay to collect on its receivables? How long does merchandise stay around before it is sold? How long does Slowpay take to pay its bills? We can first calculate the three turnover ratios:

Inventory turnover = $30,000/6,000 = 5 times Receivables turnover = $50,000/2,000 = 25 times Payables turnover = $30,000/3,750 = 8 times

We use these to get the various periods:

Inventory period = 365/5 = 73 days Receivables period = 365/25 = 14.6 days Payables period = 365/8 = 45.6 days

All told, Slowpay collects on a sale in 14.6 days, inventory sits around for 73 days, and bills get paid after about 46 days. The operating cycle here is the sum of the inventory and receivables periods: 73 + 14.6 = 87.6 days. The cash cycle is the difference between the operating cycle and the payables period: 87.6 - 45.6 = 42 days.

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