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What assurance do we have that the receivable days figure is the representative of the collection period? How did accountants devise this formula?
Accountants didn’t ‘devise’ a formula, and you should not learn it in terms of formulae.
Surely, if (for example) sales on average are $1000 a day, and average receivables are $10,000, then it would seem that it is taking on average 10000/1000 = 10 days to collect receivables.
As I make clear in my free lecture on this, we certainly do not have an assurance that it is correct – usually in the exam we only have the year end receivables available and they could be unusually high or low. Also, sales may have been growing (or falling) during the year, and this would distort it as well.
All we can do is make the best use of the information available and come up with an estimate. Interpreting accounts in this way is not an exact science – all we are after is an indication of what is happening. Most of the marks on this in the exam are for the discussion.
Thanks John! This means that I sell for 10 days without collecting and start collecting the $1000 cash on the 11th day to remain with an average receivables of $10,000 on the subsequent days.
Are raw materials not part of cost of production? Cost of production=opening raw materials+material purchases-closing materials+opening WIP – closing WIP. Therefore the formula for Raw Material days=Average raw materials divided by Cost of Production?
Yes to your first sentence 🙂
Raw materials are part of the cost of production – yes. But so are the labour and overhead costs of production.
So strictly, raw materials days should be calculated on the raw material usage. Usually we do not have enough information and so we use the cost of production instead.
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