[MUSIC] So now we've talked about the main working capital items. Let's talk about the financial ratios that we have in corporate finance to analyze working capital management for real world company. Okay. So the first ratio that we're going to discuss as an example is the Average Collection Period in Days. Okay. So that has to do with accounts receivable. Right? Companies have generated accounts receivable due to the nature of the business, and this ratio will tell you how long does it take for a company to collect its receivables. Right? The way you compute it is by dividing the total amount of accounts receivable in the balance sheet by the companies daily revenue. Okay? So let me give an example here, suppose a company has one hundred $100 million in receivable and you have a total annual revenue of $2 billion. Okay? That means you're daily revenue divided by 365. Right? Would be 5.5 million. Okay, and then what you do is you divide the total receivable by the daily revenue, and the answer you get is an answer in days. Okay? So it means that it takes, on average during the year, it takes 18 days for a company to collect its receivables. Okay? And we have similar ratios for the other working capital items. Inventory and payables. Okay? Those ratios are usually based on operating cost. So the definition of operating cost that we use to calculate the ratios is the sum of COGS and SGA. So cost of goods sold plus selling general and administrative expenses. And then the definitions are very similar. The average days in inventory is the total amount of inventory that a company has divided by the daily operating cost. Okay, so that measures how many days of inventory a company has in the balance sheet. Right? And then we have the payables. Remember the payables are the other side of the equation. Right? So the company borrowing money from suppliers. And this ratio, the average payable period tells us how many days of payable the company is carrying in the balance sheet. Okay? And then at the end, we put all the working capital items together and we compute this important ratio to talk about working capital management which is the Cash Conversion Cycle. Okay? So the conversion cycle is equal to the collection period. Okay? Plus the days of inventory minus the payable period. Remember accounts payable always answers with the opposite sign. Right? And it should be clear but let me just make sure everybody is understanding this. Right? So, let's ask a question now. So what does the cash conversion cycle measure? Let's see if you can can answer that one. All right, going back to the receivable example it should be pretty simple. Right? That what the cash conversion cycle measures is how much time it takes for a company to generate cash from its working capital investments. Right? So think about it this way. Right? So you have to buy some inventory. Right? So suppose your selling a certain good. Right? The first thing a company has to do is to buy inventory and hold the inventory until you sell the good. Right? And then when you sell it, you might generate some receivables. Right? So, if you sum the collection period in the inventory, in the days in inventory you're gonna be taking those two times into account. Right? How much times it takes for you to sell the goods and then how much time it takes to get the money, for your customers to pay you fully. Okay? And on the other hand you have payables. Right? Payables are always the opposite sign, companies are borrowing from suppliers. The payable, having payables is going to shorten your cash conversion cycle. Right? Cuz you're essentially getting cash, borrowing money from your supplier. So if you calculate cash conversion cycles for a real world companies, really, we have a very useful measure of how much time it takes for a company to generate cash from its working capital investments. Okay? In our assignment, we're going to calculate several cash conversion cycles in a real world examples. Let me give a few examples here. Okay? We are going to use two companies that distribute heavy equipment by companies like Caterpillar. Right? Caterpillar produces diesel engines, tractors, very heavy machinery. These two companies, Power Solutions International and Toromont International, what they do is they distribute this heavy equipment. Okay? So they get the machines from Caterpillar and then they sell to other parties. They distribute them. Okay? So what this example will show you is that the cash conversion cycles really depend on the nature of the business. Right? So PSI, a little bit more on PSI here. It's a manufacturer. It also has some manufacturing business. Right? And like we've said, it distributes engines and power systems for companies like Caterpillar. Okay? So here the working capital ratios for companies. Okay? You can see that, there are very significant numbers here. Right? So if you look at the inventory that PSI has for example. Right? Let's say in 2014, PSI was carrying 98 days of inventory in its balance sheet. Okay? So you have 98 days of inventory, that means it takes 98 days on average for PSI to sell the goods that it has on inventory. Right? You also have some receivables and payables. Right? In the end, if we sum inventory to say, to the collection period and then we divide to payables we get the average cash conversion cycle for PSI which is 117 days on average. Right? So that means it takes virtually a third of the year. Right? For PSI to generate cash from working capital investment. Right? From the day that they buy the inventory until the day that they get paid it takes them 120 days. Okay, taking payables into account. Right? Like payables are findings. And just to show you that this is not bad management. Right? The compared to Toromont also has a similar situation. Right? Because of the nature of the business you have to carry a very large amount of goods in inventory, 111 days. Okay? So you end up with a very long cash conversion cycle. Okay? Of course not all companies are like that. We can compare these two companies with a retailer like Walmart. Okay? The retailer will have some inventory. Right? But a company like Walmart really does not take very long to get paid. There are some sales on credit cards that don't take as long, so what Walmart ends up with is a very short cash collection cycle. Okay. So it only takes 12 days for a company like Walmart to generate cash from its working capital investment. Right? So what we learned is that the cash conversion cycle really depends on the nature of the business because Toromont and PSI have this need to hold large inventory. They are going to end up with very low cash conversion cycle. Right? Distributing engines requires them to keep a lot of inventory. Okay. But of course this is an important characteristic of the business for a financial manager to think about. The financial manager of these companies, Toromont and PSI, has to take that into account and think about how the short term planning of the company is gonna be made, that's where we're going next. We're gonna be thinking about how working capital needs like inventory and other working capital needs are going to generate specific needs for short-term financial planning.