Average Age Of Inventory

What Does Average Age Of Inventory Mean? The average number of days it takes for a firm to sell a product it is currently holding as inventory to consumers. The formula to calculate the average age of inventory is C/G x 365, where C is the average cost of inventory at its present level and G is the cost of goods sold, multiplied by the number of days in a year. For example, if the inventory is valued at $100,000 and the cost of goods sold is $600,000, the average age of inventory is 60.8 days. That means that on average it takes a firm approximately two months to sell a piece of inventory. Can also be referred to as days to sell inventory.

Investopedia explains Average Age Of Inventory A high average age of inventory can indicate that a firm is not properly managing its inventory or that it has a substantial amount of goods that are proving difficult to sell. Average age of inventory can help purchasing agents make buying decisions and help managers make pricing decisions (e.g. discounting existing inventory to move product and increase cash flow). The higher a firms average age of inventory, the greater its exposure to obsolescence risk, the risk that the accumulated products will lose value in a soft market. Average age of inventory is critical in industries with rapid sales and product cycles (such as technology). If a firm is unable to move inventory, it will take an inventory write-off charge, meaning that the products were not equivalent to their stated value on a firms balance sheet.

A timeless piece of advice for investors will always be to stick to the fundamentals. Why do fundamentals matter? Well, in the end, a solid company with strong fundamentals and a management team who is consistent and accountable to investors will likely remain a good longterm company. In other words, your average S&P 500 blue chip firm will likely still be around and their business will, to some degree, grow whether in an up or down market. Additionally, the way the large players of the institutional arena operate attests to the importance of fundamentals. The asset management wings of these heavyweights are not buying tens of millions of shares based on a hunch or whim. They derive model valuations based on fundamentals. In this article, we'll provide an overview of one important fundamental metric: the cash conversion cycle. What Is the Cash Conversion Cycle? Speculative trading bubbles will likely come and go, and pure anxiety and sentiment from investors of all sizes will always factor into the market. It is, however, no secret that to pick a solid performer when the market is slow or under attack takes a little more know-how. The cash conversion cycle (a.k.a. net operating cycle), can tell you how cash is moving through a company in terms of duration. This ratio is vital because the cycle represents the number of days a firm's cash remains tied up within the operations of the business The cash conversion cycle is a derived ratio and is generally not part of ratio comparison sections found in financial portals or websites. You can, however, construct the three ratios that compose the calculation of the cash conversion cycle by taking a little time to look at a firm's inventory, receivables and payables: Cash Conversion Cycle (or Net Operating Cycle) = Average Inventory Collection Period + Average Receivables Processing Period Average Payables Period Most financial websites will present these components in a standard ratio comparison, so you need not worry about deriving the ratio independently. The cash conversion cycle simply indicates the duration of time it takes the firm to convert its activities requiring cash into cash returns. Therefore, a downward trend in this cycle is a positive signal while an upward trend is a negative signal. Why is this so? When the cash conversion cycle shortens, cash becomes free for other uses such as investing in new capital, spending on equipment and infrastructure, as well as preparing for possible share buybacks down the road. On the flip side, when the cash conversion cycle lengthens, cash remains tied up in the firm's core operations, leaving little leeway for other uses of this cash flow. Below is a numerical example of this calculation:

For demonstration purposes, we have steadily held the payables processing period at 72 days. It is clear from the above example that the firm's financial condition, from the perspective of the cash conversion cycle, has improved. Inventory processing and accounts receivable turnover has improved for firm A from year one to year three, implying that the processing period of each has declined. Conclusion In taking the time to find the cash conversion cycle, pay attention to the trend of its three general components with special emphasis on the payables processing period. Sometimes shorter processing periods for inventory and/or receivables can be largely offset by increases in the processing period for accounts payables. The processing period for accounts payables will increase if the firm is paying its creditors and suppliers at a slower rate. The main point to remember, however, is that an understanding of each of the three factors in the formula can help pinpoint the trend not only in the cash conversion cycle but also in the individual processing periods themselves, insights that can give both a synopsis of operational efficiency and the justification behind it.

The cash conversion cycle (CCC) is one of several measures of management effectiveness. It measures how fast a company can convert cash on hand into even more cash on hand. The CCC does this by following the cash as it is first converted into inventory and accounts payable (AP), through sales and accounts receivable (AR), and then back into cash. Generally, the lower this number is, the better for the company. Although it should be combined with other metrics (such as return on equity and return on assets) it can be especially useful for comparing close competitors because the company with the lowest CCC is often the one with better management. In this article, we'll explain how CCC works and show you how to use it to evaluate potential investments.

What Is It? The CCC is a combination of several activity ratios involving accounts receivable, accounts payable and inventory turnover. AR and inventory are short-term assets, while AP is a liability; all of these ratios are found on the balance sheet. In essence, the ratios indicate how efficiently management is using short-term assets and liabilities to generate cash. This allows an investor to gauge the overall health of the company. (For further reading, see Reading The Balance Sheet and Introduction To Fundamental Analysis: The Balance Sheet.) How do these ratios relate to business? If the company sells what people want to buy, cash cycles through the business quickly. If management cannot figure out what sells, the CCC slows down. For instance, if too much inventory builds up, cash is tied up in goods that cannot be sold - this is not good news for the company. In order to move out this inventory quickly, management might have to slash prices, possibly selling its product at a loss. If AR is handled poorly, it means that the company is having difficulty collecting payment from customers. This is because AR is essentially a loan to the customer, so the company loses out whenever customers delay payment. The longer a company has to wait to be paid, the longer that money is unavailable for investment elsewhere. On the other hand, the company benefits by slowing down payment of AP to its suppliers, because that allows the company to make use of the money for longer. (To learn more, read Measuring Company Efficiency and Understanding The Time Value Of Money.) The Calculation To calculate CCC, you need several items from the financial statements:

Revenue and cost of goods sold (COGS) from the income statement Inventory at the beginning and end of the time period AR at the beginning and end of the time period AP at the beginning and end of the time period The number of days in the period (year = 365 days, quarter = 90)

Inventory, AR and AP are found on two different balance sheets. If the period is a quarter, then use the balance sheets for the quarter in question and the ones from the preceding period. For a period of a year, use the balance sheets for the quarter (or year end) in question and the one from the same quarter a year earlier. This is because, while the income statement covers everything that happened over a certain period of time, balance sheets are only snapshots of what the company was like at a particular moment in time. For things like AP, you want an average over the period of time you are investigating, which means that AP from both the time period's end and beginning are needed for the calculation. Now that you have some background on what goes into calculating CCC, let's take a look at the formula: CCC = DIO + DSO - DPO Let's look at each component and how it relates to the business activities discussed above. Days Inventory Outstanding (DIO): This addresses the question of how many days it takes to sell the entire inventory. The smaller this number is, the better. DIO = Average inventory/COGS per day Average Inventory = (beginning inventory + ending inventory)/2 Days Sales Outstanding (DSO): This looks at the number of days needed to collect on sales and involves AR. While cash-only sales have a DSO of zero, people do use credit extended by the company, so this number is going to be positive. Again, smaller is better. DSO = Average AR / Revenue per day Average AR= (beginning AR + ending AR)/2 Days Payable Outstanding (DPO): This involves the company's payment of its own bills or AP. If this can be maximized, the company holds onto cash longer, maximizing its investment potential; therefore, a longer DPO is better. DPO = Average AP / COGS per day

Average AP = (beginning AP + ending AP)/2 Notice that DIO, DSO and DPO are all paired with the appropriate term from the income statement, either revenue or COGS. Inventory and AP are paired with COGS, while AR is paired with revenue. Practical Application Let's use some real numbers from a retailer as an example to work through. The data below is from Barnes & Noble's 10-K reports filed for the fiscal years ending January 28, 2006 (fiscal year 2005) and January 29, 2005 (fiscal year 2004). All numbers are in millions of dollars. Item Revenue COGS Inventory A/R A/P Average Inventory Average AR Average AP Fiscal Year 2005 Fiscal Year 2004 5103.0 Not needed 3533.0 Not needed 1314.0 1274.6 99.1 91.5 828.8 745.1 ( 1314.0 + 1274.6 ) / 2 = 1294.3 ( 99.1 + 91.5 ) / 2 = 95.3 ( 828.8 + 745.1 ) / 2 = 787.0

Now, using the above formulas, CCC is calculated:

DIO = $1294.3 / ($3533.0 / 365 days) = 133.7 days DSO = $95.3 / ($5103.0 / 365 days) = 6.8 days DPO = $787.0 / ($3533.0 / 365 days) = 81.3 days CCC = 133.7 + 6.8 - 81.3 = 59.2 days What Now? As a stand alone number, CCC doesn't mean very much. Instead, it should be used to track a company over time and to compare the company to its competitors. When tracking over time, determine CCC over several years and look for an improvement or worsening of the value. For instance, for fiscal year 2004, Barnes & Noble's CCC was 68.9 days, so the company has shown an improvement between the ends of fiscal year 2004 and fiscal year 2005. Barnes & Noble achieved this improvement by decreasing DIO by 4.5 days, increasing DSO by 1.5 days and increasing DPO by 6.7 days. While between these two years the change is good, the slight increase in DSO might merit more investigation, such as looking further back in time. CCC changes should be examined over several years to get the best sense of how things are changing.

CCC should also be calculated for the same time periods for the company's competitors, such as Borders Group and Amazon.com. For fiscal year 2005, Borders' CCC was 101.2 days (168.4 + 12.0 - 79.2). Compared to Borders Group, Barnes & Noble is doing a better job at moving inventory (lower DIO), is quicker at collecting what it is owed (lower DSO) and keeps its own money a bit longer (higher DPO). Remember, however, that CCC should not be the only metric used to evaluate either the company or the management; return on equity and return on assets are also valuable tools for determining the effectiveness of management. (For more insight, check out Keep Your Eyes On The ROE, Understanding The Subtleties Of ROA Vs. ROE and ROA On The Way.) Interestingly, Amazon's CCC for the same period is negative,coming in at -31.2 days (29.6 + 10.2 - 71). This means that Amazon doesn't pay its suppliers for the books that it buys until after it receives payment for selling those books; therefore, Amazon doesn't have a need to hold very much inventory and still hold onto its money for a longer period of time. Although online retailers have this advantage, there are other issues that keep Borders and Barnes & Noble in the game. After all, you cannot curl up in those comfortable chairs with a fresh latte at Amazon despite Amazon's success, there is still something to be said for the experience of going to a bookstore. Wrapping It Up The cash conversion cycle is one of several tools that can help you evaluate management, especially if it is calculated for several consecutive time periods and for several competitors. Decreasing or steady CCCs are good, while rising ones should motivate you to dig a bit deeper. CCC is most effective with retail-type companies, which have inventories that are sold to customers. Consulting businesses, software companies and insurance companies are all examples of companies for whom this metric is meaningless.

Cash is something companies love to have. But can they have too much of the stuff? Provided things are going well, debt financing helps a company gear up to boost returns, but investors know the dangers of debt. When things don't go as planned, debt can spell trouble.

But what about a company's cash position? If excess debt is a bad thing, does it follow that a lot of cash is a good thing? At first glance, it makes sense for investors to seek out companies with plenty of cash on the balance sheet. After all, cash offers protection against tough times, and it also gives companies more options for future growth. Tutorial: Introduction To Fundamental Analysis <script language="JavaScript" type="text/javascript"> document.write('<a href="http://ops.investopedia.com/RealMedia/ads/click_lx.ads/investopedia.com/stocks/L23/742 6190/x20/Investo/IPFXC1102_10_250x250_AF_OPT/IPFXC1102_10_250x250_AF_OPT_201 1-02-01.html/66506667656b335354347341437a4831? http://clk.atdmt.com/FXM/go/169829036/direct;wi.250;hi.250/01/7426190" target="_blank"><img src="http://view.atdmt.com/FXM/view/169829036/direct;wi.250;hi.250/01/7426190"/></a>'); </script><noscript><a href="http://ops.investopedia.com/RealMedia/ads/click_lx.ads/investopedia.com/stocks/L23/742 6190/x20/Investo/IPFXC1102_10_250x250_AF_OPT/IPFXC1102_10_250x250_AF_OPT_201 1-02-01.html/66506667656b335354347341437a4831? http://clk.atdmt.com/FXM/go/169829036/direct;wi.250;hi.250/01/7426190" target="_blank"><img border="0" src="http://view.atdmt.com/FXM/view/169829036/direct;wi.250;hi.250/01/7426190" /></a></noscript> The Theories Unfortunately, nothing is quite that simple. For investors digging into company fundamentals, a big pile of cash can signal many things - good and bad. How investors interpret cash reserves depends on how the cash got there, the kind of business the company is and what managers plan to do with the cash. Corporate finance textbooks say that each firm has its own appropriate cash level, and companies ought to keep just enough cash to cover their interest, expenses and capital expenditures; plus they should hold a little bit more in case of emergencies. The current ratio and the quick ratio help investors determine whether companies have enough coverage to meet near-term cash requirements. Theory also holds that any extra cash over and above those levels should be redistributed to shareholders either through dividends or share buybacks. If the company then discovers a new investment opportunity, managers should turn to the capital markets to raise the needed funds. Good Reasons for Extra Cash That said, there are often good reasons to find more cash on the balance sheet than financial principles suggest prudent. To start, a persistent and growing reserve often times signals strong company performance. Indeed, it shows that cash is accumulating so quickly that management doesn't have time to figure out how to make use of it.

Highly successful firms in sectors like software and services, entertainment and media don't have the same levels of spending required by capital-intensive companies. So their cash builds up. By contrast, companies with a lot of capital expenditure, like steel makers, must invest in equipment and inventory that must be regularly replaced. Capital-intensive firms have a much harder time maintaining cash reserves. Investors should recognize, moreover, that companies in cyclical industries, like manufacturing, have to keep cash reserves to ride out cyclical downturns. These companies need to stockpile cash well in excess of what they need in the short term. Bad Reasons for Extra Cash All the same, textbook guidelines should not be ignored. High levels of cash on the balance sheet can frequently signal danger ahead. If cash is more or less a permanent feature of the company's balance sheet, investors need to ask why the money is not being put to use. Cash could be there because management has run out of investment opportunities or is too short sighted and doesn't know what to do with the cash. Sitting on cash can be an expensive luxury because it has an opportunity cost, which amounts to the difference between the interest earned on holding cash and price paid for having the cash as measured by the company's cost of capital. If a company, say, can get 20% return on equity investing in a new project or by expanding the business, it is a costly mistake to keep the cash in the bank. If the project's return is less than the company's cost of capital, the cash should be returned to shareholders. Don't be fooled by the popular explanation that extra cash gives managers more flexibility and speed to make acquisitions when they see fit. Companies that hold excess cash carry agency costs whereby they are tempted to pursue "empire building". Top managers can fritter away cash on wasteful acquisitions and bad projects in a bid to boost their personal power and prestige. With this mind, be wary of balance sheet items like "strategic reserves" and "restructuring reserves". They are often just excuses for hoarding cash. Even worse, a cash-rich company runs the risk of being careless. The company may fall prey to sloppy habits, including inadequate control of spending and an unwillingness continually to prune growing expenses. Large cash holdings also remove some of managers' pressure to perform. There is much to be said for companies that raise investment funds in the capital markets. Capital markets bring greater discipline and transparency to investment decisions and so reduce agency costs. Cash piles let companies skirt the open process and avoid the scrutiny that goes with it. Conclusion To play it safe, investors should look at cash position through the sieve of financial theory and

work out an appropriate cash level. By taking into account the firm's future cash flows, business cycles, its capital expenditure plans, emerging liability payments and other cash needs, investors can calculate how much cash a company really needs.