By Dean Kaplan+
When the credit department makes credit decisions, it must evaluate a potential new customer’s ability to generate cash which can be used to pay its creditors. Determining that the customer operates with an adequate level of working capital relative to the industry will lead to a positive credit decision and fewer debt collections in the future. This is the final article in a nine part series of articles about financial statement analysis. This article will focus on understanding the potential new customer’s operating cycle.
A company’s operating cycle is the number of days from inventory purchase to receiving payment for the inventory that was sold. The average number of days across all customers is considered the length of the company’s operating cycle. The length of this cycle will affect the company’s need for working capital to operate effectively. A company with a very short operating cycle will require less working capital to operate than a company with a very long cycle.
Days of Inventory on Hand measures the number of days it takes to sell the inventory of a company. To calculate the Days of Inventory on Hand, the credit department must first calculate Inventory Turnover. Inventory Turnover measures the cost of goods sold during the specified time period, and can be taken directly from the customer’s income statement. If the cost of good sold is divided by the average inventory during the same period, this will equal the number of times the inventory was depleted and had to be replaced, also known as Inventory Turnover.
Inventory Turnover = Cost of Goods Sold ÷ Average Inventory
For example, $100,000/$20,000 = 5.0 inventory turns
Next, the credit department should calculate the number of days it took to deplete (turn) the inventory. This is called Days Inventory on Hand.
Days Inventory on Hand = 365 Days ÷ Inventory Turnover.
For example, 365/5 = 73 days
The Average Collection period is another operating cycle ratio which measuring the number of days it takes to turn accounts receivable into cash. To calculate this ratio, the credit department must first calculate Accounts Receivable Turnover. In most cases, a rough estimate of Accounts Receivable Turnover is represented by the Total sales for the specified period divided by the average accounts receivable for the period.
Accounts Receivable Turnover = Total Sales ÷ Average Accounts Receivable.
For example, $200,000/$50,000 = 4.0
In this example, accounts receivable is turned into cash 4 times in the time period.
The next thing the credit department should calculate is the average number of days it takes to turn the accounts receivable into cash.
Average Collection Period = 365 Days ÷ Accounts Receivable Turnover.
For example, 365/4 = 91 days
The credit department now has all the data needed to calculate the customer’s operating cycle:
Operating Cycle = Days Inventory on Hand + Average Collection Period
For example, 73 + 91 = 164 days to go from inventory purchase to cash from sale of inventory.
The reason why the length of a customer’s operating cycle matters is because it represents how efficiently the customer manages its current assets. By comparing its cycle to the industry and to other companies within the industry the credit department can see any discrepancies and look for answers if necessary. In addition, the operating cycle can help the credit department identify an inadequate level of working capital. Working Capital is pumped up when accounts receivable are turned into cash. Working capital is depleted when accounts payable are paid with cash. If accounts receivable are not increasing enough to keep up with accounts payable, then working capital is not adequate and a potential creditor must ask how the customer’s payment obligations will be met.
Days Payable Outstanding is another ratio which will help the credit department understand the customer’s working capital picture. It measures the number of days it takes the customer to pay its vendors for purchases. The credit department must first calculate the Accounts Payable Turnover for the specified time period.
Accounts Payable Turnover = Total Purchases ÷ Accounts Payable
For example, $50,000/$5,000 = 10 turns
Where Total Purchases = Ending Inventory – Beginning Inventory + Cost of Goods Sold
Accounts Payable is the Accounts Payable figure from the Balance Sheet
Days Payable Outstanding = 365 Days ÷ Accounts Payable Turnover
For example 365/10 = 36.5 days
In the example, the customer pays its vendors on average in 36.5 days. Comparing this number to the industry and other companies within the industry will tell the credit department if further investigation is warranted.
When making credit decisions, the credit department takes many factors into consideration. Financial statement analysis is particularly important when a new customer plans to buy large quantities of product and requires extensive credit. Taking the time for due diligence will enable the credit department to make the credit decision with confidence and will likely prevent future debt collections. Thorough credit analyses are particularly important during tough economic times. Many companies experience a squeezing of working capital when the economy goes south. Having less working capital makes it difficult for a customer to keep up with its debts. Hiring collection agencies to help with accounts receivable collections can be a very effective way of managing debt problems. Collection agencies are experts in debt collections. Often times, when working with a large delinquent customer, negotiation skills become paramount. If a dispute is involved, professional debt collectors have extensive experience and can overcome many obstacles that the debtor might try to put up in order to drag out or avoid the paying debt. Since most commercial collection agencies work on a contingency basis, payment is only required when the debt is collected. When times are tough and staffing is tight, collection agencies might be a positive choice.
If you missed the previous articles in this series, check them out below:
And be sure to check out the rest of the articles in this series:
- Credit Analysis
- Financial Statement Analysis
- Financial Statement Reliability
- Credit Investigation Levels
- Net Income Analysis
- Financial Strength of a Potential Customer
- Liquidity Position of a Potential Customer
- Cash Flow of a Potential Customer
- Operating Cycle of a Potential Customer
The Kaplan Group is a boutique collection agency specializing in large (over $10,000) debt collections due from businesses. Founded in 1991, the company has a stellar reputation (A+ rating with the Better Business Bureau) and is recognized as one of the leading collection agencies for results on large and complex matters.