In this lesson, we're going to tackle the operational analysis. We have already learned that you can get information about the numbers stores, and often the number of employees in the opening sections of the 10 K. We can also read the first part of the mdna and the letters to the shareholders to get a sense of how well the company is operating in the eyes of the executives and the chairman. But we should also try and benchmark operating performance to enable a comparison against its peers. The benchmark measures will vary considerably by industry, so you'll first need to understand the industry and its business drivers. If it's a labor intensive industry, then you'll be looking at comparing sales to the number of employees. If it's a capital intensive industry, you may want to look at asset turnover, that is sales divided by total assets to get a sense of how efficient the business is utilizing its asset base to generate revenue in the region.

Retail industry, we may want to consider same store sales. So to get this data, it may take some digging and some calculations for the Home Depot. Thankfully they have helped us out once again with the five year summary table. At the bottom of this table, they have provided us with information about the number of stores the number of employees save store sales, which is interesting in and of itself. We can also come up with productivity measures such as the sales per associate, or the annual sales per store and compare this against prior years and competitors such as Lowe's to evaluate the operational performance of Home Depot. I also like to look at the other administrative efficiency ratios as well.

Inventory turnover is important in a retail context. Once again, Home Depot has already calculated this information for us in the five year table. But if we had to do this for ourselves, we would simply take the cost of sales and divide it by the hour. Balance of inventory that we would find on the balance sheet. inventory turnover is a measure of how many times Home Depot has sold all of its inventory in a given year. high numbers are good and indicate a strong selling and merchandising capability.

Low numbers of inventory turnover might indicate issues with obsolescence or poor selection. We can also look at the average collection period for receivables. To evaluate how effective the company isn't managing receivables, the average collection period is calculated as the average accounts receivable balance divided by the average daily sales, which is your annual net sales divided by 365 days Typically, this isn't likely a key indicator for retail business, as transactions are largely cash based, but for many other businesses further up the value chain. Collecting receivables is a variable activity. weaker collection periods may indicate that the company is more likely to experience higher bad debts in future periods, or they may be extending credit to generate sales to less creditworthy customers. A higher collection period could also indicate a mismanagement of receivables, something that is unfortunately all too common in many businesses as the companies themselves fear losing customers by enforcing their own credit terms.

The problem with having too much inventory or too many receivables is that it ties up working capital, many people see working capital is a good thing. And this is true to a certain extent. But the way you should view working capital is as a cash investment. As long as you hold inventory and receivables. You need to finance that investment with your cash reserves. Now, it's true that you can finance a portion of the working capital with bank lines perhaps lean on your suppliers a little bit to provide you with some credit terms to help you out but were to be able to finance all of your working capital from these two sources alone.

And thus your out of pocket for the difference until you can convert these items to cash. Which brings us to another helpful measure. And that is the cash conversion cycle. And this measure calculates the number of days a company takes to sell its inventory, collect its receivables, and pay its suppliers. And it's calculated as the days of inventory outstanding, plus the days of sales outstanding, less the days of payables outstanding. The bigger this number as expressed in number of days, the more financing that is going to be required.

Now, I got involved with a company a number of years ago that had a huge amount of working capital, both in inventory and receivables. The company was bending over backwards to serve its customers. For example, we would create unique Order Type inventory without any boy commitments from our customers that would more often than not leave us stranded with excess inventory. On top of that, we let our customers pay us on terms which were twice as long as our credit policy. We had inventory located in 58 warehouses across the continental United States. And it took us weeks just to figure out where all our inventory was being stored.

Our supply chain required a very long lead time, and thus it was justified on that basis. Instead of striving for just in time inventory, we could adopt a policy of just in case inventory. And just in case our raw materials got held up in customs, just in case one of our big customers needed more inventory than they had originally indicated. So it's not hard to see the results of these sort of attitudes. We literally had hundreds of millions of dollars tied up needlessly in working capital, and we were quickly using up all of our available financing capacity. So we were Private Equity Partners involved with the company, and at the time the company was struggling.

They thought they had a strategic issue, which may have been true, but in terms of priorities they had far more pressing operational issues. My boss at the time told the VP of procurement to stop all inventory purchases, much to the VP dismay, the concern he raised was that we'd run out of inventory. And our seemingly obvious rebuttal was to sell the inventory we already had first and then worry about making new sales. It was a complete hundred and 80 degree shift in the culture from making sales to focusing in on operational efficiencies. And in the end, after a couple of years of involvement, we took a $500 million sale business that wasn't making any money and shrunk it down to a $300 million a year sale business and achieve the best profits the company's ever achieved in its history. It all started from making the operational metrics first and worrying about the strategy later.

So there's your war story for the day on why we need to measure and manage operational details. Until next time, don't stop to get to the top and hit the top. Don't stop