What Is the Average Age of Inventory?

The average age of inventory is the average number of days it takes for a firm to sell off inventory. It is a metric that analysts use to determine the efficiency of sales. The average age of inventory is also referred to as days’ sales in inventory (DSI).

Formula and Calculation of Average Age of Inventory

The formula to calculate the average age of inventory is:


$\begin{aligned} &\text{Average Age of Inventory}= \frac{ C }{ G } \times 365 \\ &\textbf{where:} \\ &C = \text{The average cost of inventory at its present level} \\ &G = \text{The cost of goods sold (COGS)} \\ \end{aligned}$​Average Age of Inventory=GC​×365where:C=The average cost of inventory at its present levelG=The cost of goods sold (COGS)​

What the Average Age of Inventory Can Tell You

The average age of inventory tells the analyst how fast inventory is turning over at one company compared to another. The faster a company can sell inventory for a profit, the more profitable it is. However, a company could employ a strategy of maintaining higher levels of inventory for discounts or long-term planning efforts. While the metric can be used as a measure of efficiency, it should be confirmed with other measures of efficiency, such as gross profit margin, before making any conclusions.

The average age of inventory is a critical figure in industries with rapid sales and product cycles, such as the technology industry. A high average age of inventory can indicate that a firm is not properly managing its inventory or that it has an inventory that is difficult to sell.

The average age of inventory helps purchasing agents make buying decisions and managers make pricing decisions, such as discounting existing inventory to move products and increase cash flow. As a firm’s average age of inventory increases, its exposure to obsolescence risk also grows. Obsolescence risk is the risk that the value of inventory loses its value over time or in a soft market. If a firm is unable to move inventory, it can take an inventory write-off for some amount less than the stated value on a firm’s balance sheet.

Example of How to Use the Average Age of Inventory

An investor decides to compare two retail companies. Company A owns inventory valued at $100,000 and the COGS is $600,000. The average age of Company A’s inventory is calculated by dividing the average cost of inventory by the COGS and then multiplying the product by 365 days. The calculation is $100,000 divided by $600,000, multiplied by 365 days. The average age of inventory for Company A is 60.8 days. That means it takes the firm approximately two months to sell its inventory.

Conversely, Company B also owns inventory valued at $100,000, but the cost of inventory sold is $1 million, which reduces the average age of inventory to 36.5 days. On the surface, Company B is more efficient than Company A.

What Is Average Outstanding Balance?

An average outstanding balance is the unpaid, interest-bearing balance of a loan or loan portfolio averaged over a period of time, usually one month. The average outstanding balance can refer to any term, installment, revolving, or credit card debt on which interest is charged. It may also be an average measure of a borrower’s total outstanding balances over a period of time.

Average outstanding balance can be contrasted with average collected balance, which is that part of the loan that has been repaid over the same period.

Understanding Average Outstanding Balance

Average outstanding balances can be important for several reasons. Lenders often have a portfolio of many loans, which need to be assessed in aggregate in terms of risk and profitability. Banks use the average outstanding balance to determine the amount of interest they pay each month to their account holders or charge to their borrowers. If a bank has a large outstanding balance on its lending portfolio it could indicate that they are having trouble collecting on their loans and may be a signal for future financial stress.

Many credit card companies also use an average daily outstanding balance method for calculating interest applied to a revolving credit loan, particularly credit cards. Credit card users accumulate outstanding balances as they make purchases throughout the month. An average daily balance method allows a credit card company to charge slightly higher interest that takes into consideration a cardholder’s balances throughout the past days in a period and not just at the closing date.

For borrowers, credit rating agencies will review a consumer’s outstanding balances on their credit cards as part of determining a FICO credit score. Borrowers should show restraint by keeping their credit card balances well below their limits. Maxing out credit cards, paying late, and applying for new credit increases one’s outstanding balances and can lower FICO scores.

Interest on Average Outstanding Balances 

With average daily outstanding balance calculations, the creditor may take an average of the balances over the past 30 days and assess interest on a daily basis. Commonly, average daily balance interest is a product of the average daily balances over a statement cycle with interest assessed on a cumulative daily basis at the end of the period.

Regardless, the daily periodic rate is the annual percentage rate (APR) divided by 365. If interest is assessed cumulatively at the end of a cycle, it would only be assessed based on the number of days in that cycle.

Other average methodologies also exist. For example, a simple average may be used between a beginning and ending date by dividing the beginning balance plus the ending balance by two and then assessing interest based on a monthly rate.

Credit cards will provide their interest methodology in the cardholder agreement. Some companies may provide details on interest calculations and average balances in their monthly statements.

Consumer Credit

Outstanding balances are reported by credit providers to credit reporting agencies each month. Credit issuers typically report a borrower’s total outstanding balance at the time the report is provided. Some credit issuers may report outstanding balances at the time a statement is issued while others choose to report data on a specific day each month. Balances are reported on all types of revolving and non-revolving debt. With outstanding balances, credit issuers also report delinquent payments beginning at 60 days past due.

Timeliness of payments and outstanding balances are the top factors that affect a borrower’s credit score. Experts say borrowers should strive to keep their total outstanding balances below 30%. Borrowers using more than 30% of total available debt outstanding can easily improve their credit score from month to month by making larger payments that reduce their total outstanding balance.

When the total outstanding balance decreases, a borrower’s credit score improves. Timeliness, however, is not as easy to improve since delinquent payments are a factor that can remain on a credit report for seven years.

Calculating Average Outstanding Balance

Lenders typically calculate interest on revolving credit, such as credit cardsor lines of credit, using an average of daily outstanding balances. The bank adds all the daily outstanding balances in the period (usually a month) and divides this sum by the number of days in the period. The result is the average outstanding balance for the period.

For loans that are paid monthly, such as mortgages, a lender may instead take the arithmetic mean of the starting and ending balance for a statement cycle. For instance, say a home borrower has a mortgage balance of $100,000 at the start of the month and makes a payment on the 30th of the same month, reducing the outstanding principal amount to $99,000. The average outstanding balance for the loan over that period would be ($100,000-99,000)/2 = $99,500.

Frequently Asked Questions

What is an outstanding balance?

An outstanding balance is the total amount still owed on a loan.

What is an outstanding principal balance?

This is the amount of a loan’s principal amount (i.e. the dollar amount initially loaned) that is still due, and does not take into account the interest or any fees that are owed on the loan.

Where can I find my outstanding balance?

Borrowers can find this information on their regular bank or loan statements. They can also usually be pulled up from a lender’s website for viewing at any time.

What is the difference between outstanding balance and remaining balance?

Outstanding balance refers to the amount still owed on a loan from the perspective of a borrower or lender. Remaining balance instead refers to how much money remains in an account after spending or a withdrawal, from the perspective of a saver or savings bank.

What percentage of an outstanding balance is a minimum payment?

Some lenders charge a fixed percentage, such a 2.5%. Others will charge a flat fee plus a fixed percentage, such as $20 + 1.75% of the outstanding balance as the minimum payment due. Penalty fees like late fees, as well as past due amounts, will typically be added to the calculation. This would increase your minimum payment significantly.

What Is the Average Cost Basis Method?

The average cost basis method is a system of calculating the value of mutual fund positions held in a taxable account to determine the profit or loss for tax reporting. Cost basis represents the initial value of a security or mutual fund that an investor owns.

The average cost is then compared with the price at which the fund shares were sold to determine the gains or losses for tax reporting. The average cost basis is one of many methods that the Internal Revenue Service (IRS) allows investors to use to arrive at the cost of their mutual fund holdings.

Understanding the Average Cost Basis Method

The average cost basis method is commonly used by investors for mutual fund tax reporting. A cost basis method is reported with the brokerage firm where the assets are held. The average cost is calculated by dividing the total amount in dollars invested in a mutual fund position by the number of shares owned. For example, an investor that has $10,000 in an investment and owns 500 shares would have an average cost basis of $20 ($10,000 / 500).

Types of Cost Basis Methods

Although many brokerage firms default to the average cost basis method for mutual funds, there are other methods available.

FIFO

The first in, first out (FIFO) method means that when shares are sold, you must sell the first ones that you acquired first when calculating gains and losses. For example, let’s say an investor owned 50 shares and purchased 20 in January while purchasing 30 shares in April. If the investor sold 30 shares, the 20 in January must be used, and the remaining ten shares sold would come from the second lot purchased in April. Since both the January and April purchases would have been executed at different prices, the tax gain or loss would be impacted by the initial purchase prices in each period.

Also, if an investor has had an investment for more than one year, it would be considered a long-term investment. The IRS applies a lower capital gains tax to long-term investments versus short-term investments, which are securities or funds acquired in less than one year. As a result, the FIFO method would result in lower taxes paid if the investor had sold positions that were more than a year old.

LIFO

The last in first out (LIFO) method is when an investor can sell the most recent shares acquired first followed by the previously acquired shares. The LIFO method works best if an investor wants to hold onto the initial shares purchased, which might be at a lower price relative to the current market price.

High-Cost and Low-Cost Methods

The high-cost method allows investors to sell the shares that have the highest initial purchase price. In other words, the shares that were the most expensive to buy get sold first. A high-cost method is designed to provide investors with the lowest capital gains tax owed. For example, an investor might have a large gain from an investment, but doesn’t want to realize that gain yet, but needs money.

Having a higher cost means the difference between the initial price and the market price, when sold, will result in the smallest gain. Investors might also use the high-cost method if they want to take a capital loss, from a tax standpoint, to offset other gains or income.

Conversely, the low-cost method allows investors to sell the lowest-priced shares first. In other words, the cheapest shares you purchased get sold first. The low-cost method might be chosen if an investor wants to realize a capital gain on an investment.

Choosing a Cost-Basis Method

Once a cost basis method has been chosen for a specific mutual fund, it must remain in effect. Brokerage firms will provide investors with appropriate annual tax documentation on mutual fund sales based on their cost basis method elections.

Investors should consult a tax advisor or financial planner if they are uncertain about the cost basis method that will minimize their tax bill for substantial mutual fund holdings in taxable accounts. The average cost basis method may not always be the optimal method from a taxation point of view. Please note that the cost basis only becomes important if the holdings are in a taxable account, and the investor is considering a partial sale of the holdings.

Specific Identification Method

The specific identification method (also known as specific share identification) allows the investor to choose which shares are sold in order to optimize the tax treatment. For example, let’s say an investor purchases 20 shares in January and 20 shares in February. If the investor later sells 10 shares, they can choose to sell 5 shares from the January lot and 5 shares from the February lot.

Example of Cost Basis Comparisons

Cost basis comparisons can be an important consideration. Let’s say that an investor made the following consecutive fund purchases in a taxable account:

• 1,000 shares at $30 for a total of $30,000
• 1,000 shares at $10 for a total of $10,000
• 1,500 shares at $8 for a total of $12,000

The total amount invested equals $52,000, and the average cost basis is calculated by dividing $52,000 by 3,500 shares. The average cost is $14.86 per share.

Suppose the investor then sells 1,000 shares of the fund at $25 per share. The investor would have a capital gain of $10,140 using the average cost basis method. The gain or loss using average cost basis would be as follows:

• ($25 – $14.86) x 1,000 shares = $10,140.

Results can vary depending on the cost-basis method chosen for tax purposes:

• First in first out: ($25 – $30) x 1,000 shares = – $5,000
• Last in first out: ($25 – $8) x 1,000 = $17,000
• High cost: ($25 – $30) x 1,000 shares = – $5,000
• Low cost: ($25 – $8) x 1,000 = $17,000

From strictly a tax standpoint, the investor would be better off selecting the FIFO method or the high-cost method to calculate the cost basis before selling the shares. These methods would result in no tax on the loss. However, with the average cost basis method, the investor must pay a capital gains tax on the $10,140 in earnings.

Of course, if the investor sold the 1,000 shares using the FIFO method, there’s no guarantee that when the remaining shares are sold that $25 will be the selling price. The stock price could decrease, wiping out most of the capital gains and an opportunity to realize a capital gain would have been lost. As a result, investors must weigh the choice as to whether to take the gain today and pay the capital gains taxes or try to reduce their taxes and risk losing any unrealized gains on their remaining investment.

What Is an Average Collection Period?

Average collection period refers to the amount of time it takes for a business to receive payments owed by its clients in terms of accounts receivable (AR). Companies use the average collection period to make sure they have enough cash on hand to meet their financial obligations. The average collection period is an indicator of the effectiveness of a firm’s AR management practices and is an important metric for companies that rely heavily on receivables for their cash flows.

How Average Collection Periods Work

Accounts receivable is a business term used to describe money that entities owe to a company when they purchase goods and/or services. Companies normally make these sales to their customers on credit. AR is listed on corporations’ balance sheets as current assets and measures their liquidity. As such, they indicate their ability to pay off their short-term debts without the need to rely on additional cash flows.

The average collection period is an accounting metric used to represent the average number of days between a credit sale date and the date when the purchaser remits payment. A company’s average collection period is indicative of the effectiveness of its AR management practices. Businesses must be able to manage their average collection period to operate smoothly.

A lower average collection period is generally more favorable than a higher one. A low average collection period indicates that the organization collects payments faster. However, this may mean that the company’s credit terms are too strict. Customers who don’t find their creditors’ terms very friendly may choose to seek suppliers or service providers with more lenient payment terms.

Formula for Average Collection Period

Average collection period is calculated by dividing a company’s average accounts receivable balance by its net credit sales for a specific period, then multiplying the quotient by 365 days.

Average Collection Period = 365 Days * (Average Accounts Receivables / Net Credit Sales)

Alternatively and more commonly, the average collection period is denoted as the number of days of a period divided by the receivables turnover ratio. The formula below is also used referred to as the days sales receivable ratio.

Average Collection Period = 365 Days / Receivables Turnover Ratio

The average receivables turnover is simply the average accounts receivable balance divided by net credit sales; the formula below is simply a more concise way of writing the formula.

Average Accounts Receivables

For the formulas above, average accounts receivable is calculated by taking the average of the beginning and ending balances of a given period. More sophisticated accounting reporting tools may be able to automate a company’s average accounts receivable over a given period by factoring in daily ending balances.

When analyzing average collection period, be mindful of the seasonality of the accounts receivable balances. For example, analyzing a peak month to a slow month by result in a very inconsistent average accounts receivable balance that may skew the calculated amount.

Net Credit Sales

Average collection period also relies on net credit sales for a period. This metric should exclude cash sales (as those are not made on credit and therefore do not have a collection period).

In addition to being limited to only credit sales, net credit sales exclude residual transactions that impact and often reduce sales amounts. This includes any discounts awarded to customers, product recalls or returns, or items re-issued under warranty.

Importance of Average Collection Period

Average collection period boils down to a single number; however, it has many different uses and communicates a variety of important information.

• It tells how efficiently debts are collected. This is important because a credit sale is not fully completed until the company has been paid. Until cash has been collected, a company is yet to reap the full benefit of the transaction.
• It tells how strict credit terms are. This is important as strict credit terms may scare clients away; on the other hand, credit terms that are too loose may attract customers looking to take advantage of lenient payment terms.
• It tells how competitors are performing. This is important because all figures needed to calculate the average collection period are available for public companies. This gives deeper insight into what other companies are doing and how a company’s operations compare.
• It tells early signals of bad allowances. This is important because as the average collection period increases, more clients are taking longer to pay. This metric can be used to signal to management to review its outstanding receivables at risk of being uncollected to ensure clients are being monitored and communicated with.
• It tells of a company’s short-term financial health. This is important because without cash collections, a company will go insolvent and lack the liquidity to pay its short-term bills.

How to Use Average Collection Period

The average collection period does not hold much value as a stand-alone figure. Instead, you can get more out of its value by using it as a comparative tool.

The best way that a company can benefit is by consistently calculating its average collection period and using it over time to search for trends within its own business. The average collection period may also be used to compare one company with its competitors, either individually or grouped together. Similar companies should produce similar financial metrics, so the average collection period can be used as a benchmark against another company’s performance.

Companies may also compare the average collection period with the credit terms extended to customers. For example, an average collection period of 25 days isn’t as concerning if invoices are issued with a net 30 due date. However, an ongoing evaluation of the outstanding collection period directly affects the organization’s cash flows.

Example of Average Collection Period

As noted above, the average collection period is calculated by dividing the average balance of AR by total net credit sales for the period, then multiplying the quotient by the number of days in the period.

Let’s say a company has an average AR balance for the year of $10,000. The total net sales that the company recorded during this period was $100,000. We would use the following average collection period formula to calculate the period:

($10,000 ÷ $100,000) × 365 = Average Collection Period

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The average collection period, therefore, would be 36.5 days. This is not a bad figure, considering most companies collect within 30 days. Collecting its receivables in a relatively short and reasonable period of time gives the company time to pay off its obligations.

If this company’s average collection period was longer—say, more than 60 days— then it would need to adopt a more aggressive collection policy to shorten that time frame. Otherwise, it may find itself falling short when it comes to paying its own debts.

Accounts Receivable (AR) Turnover

The average collection period is closely related to the accounts turnover ratio, which is calculated by dividing total net sales by the average AR balance.

Using the previous example, the AR turnover is 10 ($100,000 ÷ $10,000). The average collection period can also be calculated by dividing the number of days in the period by the AR turnover. In this example, the average collection period is the same as before: 36.5 days.

365 days ÷ 10 = Average Collection Period

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Collections by Industries

Not all businesses deal with credit and cash in the same way. Although cash on hand is important to every business, some rely more on their cash flow than others.

For example, the banking sector relies heavily on receivables because of the loans and mortgages that it offers to consumers. As it relies on income generated from these products, banks must have a short turnaround time for receivables. If they have lax collection procedures and policies in place, then income would drop, causing financial harm.

Real estate and construction companies also rely on steady cash flows to pay for labor, services, and supplies. These industries don’t necessarily generate income as readily as banks, so it’s important that those working in these industries bill at appropriate intervals, as sales and construction take time and may be subject to delays.

The Bottom Line

The average collection period is the average number of days it takes for a credit sale to be collected. During this period, the company is awarding its customer a very short-term “loan”; the sooner the client can collect the loan, the earlier it will have the capital to use to grow its company or pay its invoices. While a shorter average collection period is often better, too strict of credit terms may scare customers away.