Georgetown University McDonough School of Business POM-02

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(Oct. 2001)

Little’s Law for Finance Majors (and others)

It has been said that Little’s Law is to Operations what Newton’s Law is to Physics. L =  W
and F = m A. Two simple, yet powerful, relationships.

Here we will show how the calculation of the firm’s cash flow cycle, as sometimes described
in a Finance course, is really just an application of Little’s Law, a tool often used in the
Operations field to analyze the flow of goods or services.

Say you want to start a business from your dorm room. You go to your mother and say,
“Mom, I know you’re paying $25,000 in tuition for my education, and I’m learning lots of
cool things, but what will REALLY contribute to my education is if I start a business from my
dorm room. What I plan to do is buy a few computer components, hook them together, and
then sell my contraptions for a profit. I know a few people who would actually buy MY stuff
rather than go to a store, where they would have to pay more for it or not even be able to find
it. I simply need some money to help get me started.”

Of course, your Mother is apprehensive, cautious, anxious, nervous, worried, pessimistic, and,
just a bit humored (YOU? Start a BUSINESS?). But trying to be a good mother she shrouds
her true emotions in inquisitiveness. “Just how much would you need to start this business,
and when would I get my money back?,” she asks. She figures your lack of planning skills
will act as a natural deterrent to actually figuring out the details, thereby relieving her of the
responsibility of having to say “no” to your request.

“True, I may be majoring in Finance, but this, after all, is just simple Operations stuff. Nuts
and bolts, Mom. Here’s how a business works. First, you buy the stuff you’re going to use in
making your product. Typically they sell this stuff on some kind of terms, such that you don’t
have to pay for it until a bit later, after you receive shipment of it. Then you make your
gizmo, and then you sell it (you ship it). You don’t generally get cash in hand the instant you
sell it. That is, you may also have to sell it on some kind of terms, such that you don’t get
paid until some time later. Look. Here’s a timeline that shows the points ‘buy, ‘pay,’ ‘sell,’
and ‘get paid.’ Now, I don’t need the money from you until the exact point at which I have to
‘pay,’ and I can give you the money back the instant I ‘get paid.’ That is, I only need the
money between the points ‘pay’ and ‘get paid.’ That’s the cash flow cycle. The time between
when I have to pay, and when I get paid in return.”

Time
buy pay sell get paid

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This teaching note has been compiled by Glen Schmidt, Georgetown School of Business. All rights reserved.

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Now your Mom is getting a bit nervous. She realizes you intuitively have a plan in mind
already, and are actually making some sense. She quickly raises the hurdle as to what level of
competence you are going to have to demonstrate before she will cough up the dough.

“O.K., O.K., but give me NUMBERS. I need NUMBERS,” she exhorts with an air of
authority, mixed with desperation. Looking out the window, she sees a Caterpillar backhoe
digging a sewer main on the street in front of your house. “Look at that machine over there.
That tractor with a pick on the back. What about the company that makes THAT thing? How
long do they need the cash to operate their cash cycle? This business of running a business
must be an expensive proposition! We’re already forking out the big bucks on your behalf for
tuition at that School!”

Now you have some homework to do. Anger begins to set in. “Can you imagine? Who
woulda thunk it? Your Mom wants NUMBERS! Actual NUMBERS! This means you may
have to CALCULATE some things. EQUATIONS! NUMBERS! Can’t she see you simply
want to run a business? What’s that got to do with NUMBERS? You simply want to be a
financial ANALYST,” you think to yourself. Frustrated and dejected, you walk away. You
didn’t go to school to learn how to crunch numbers! (What were you thinking, anyway?
What did you think an analyst analyzed, the weather?)

Back in your dorm room, you calm down and your anger which had turned to frustration now
turns to determination. “I’ll get those numbers,” you resolve to yourself.

You figure these numbers must be in the annual report. So you dig out Caterpillar’s annual
report for 1999. But nowhere do you find a line item saying “this is the length of time we
needed to borrow money from our Mom this year.” After wading through all the verbiage
you find the “Financial Statements” section but here all you find is something called a
“Condensed Results of Operations” and a “Condensed Financial Position” and a “Condensed
Statement of Cash Flow.” Didn’t your accounting prof say the report should contain a
“Balance Sheet” and an “Income Statement”????

You’re not giving up. But you decide to hit the books since some time ago you had promised
your Mom you would keep up your GPA if she would keep paying for your school. And
since you couldn’t put it off any longer, you are now taking this @&#&! Operations class,
where today’s lesson on Little’s Law reads as follows:
L = W, where:
L = long-run average NUMBER of objects in the system (e.g., a count of the number
of items in a SNAPSHOT, assuming that snapshot depicts average conditions).
 = long-run average RATE at which objects arrive & depart (rates are per unit time).
W = long-run average TIME spent in the system by a typical object.

“When am I ever going to use this nonsense, anyway?,” you say to yourself. After all, I’m a
FINACE major. I’m not going to be working in some dingy factory. So who CARES about
the flow of items through some system, numbers of items, rates, times spent in the system.
You close your book. No, you slam it shut.

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You decide to study your Accounting for a change of pace. “The Balance Sheet effectively
gives you a SNAPSHOT of the firm at a specific point in time,” your book states, “while the
yearly income statement tells you what happens over the time period of one year. For
example, the ‘sales’ entry in the income statement effectively represents the average sales rate
in $ per year.”

“Here we go again. Snapshots, rates – this is no better than Operations,” you mutter, before
dozing off.

Somehow your mind has a way of processing ideas while you sleep. Effectively, it represents
a processing network… (Yes, to an Operations person, EVERYTHING looks like a
processing network. But back to the story.) You begin to dream about the life-cycle of a
caterpillar. No, about the cash flow cycle of a Caterpillar. “First the firm buys the stuff.
Then the firm pays for the stuff it buys.” Your earlier words to your Mom replay themselves
on a screen in front of you. An accounts payable ledger flares up on the screen, with entries
flowing into the accounts payable ledger when the firm buys the stuff, and flowing out when
the firm pays for the stuff. You conveniently label this average flow rate as P (the subscript
“P” stands for purchases, since you make an entry in the accounts payable ledger when you
make a purchase). You envision the average dollar balance of the accounts payable ledger as
LP, and realize the average length of time an entry stays in the ledger can be calculated as WP
= LP / P. Clearly, this length of time, WP, is the time between the points “buy” and “pay,”
representing the number of days that your purchases (payments) are outstanding.

Next you envision the warehouses holding the stuff you bought (the raw materials inventory)
and the factories holding the stuff while you are transforming it into saleable goods (the work-
in-process, or WIP, inventory) and the storage lots holding all the stuff you already finished
making (the finished goods inventory). You see materials flowing into this system at some
rate I (the “I” stands for inventory), you count the total dollar value of all types of inventory
as LI, and realize the time these materials spend within the firm is WI = LI / I. This length
of time, WI is time between the points between “buy” and “sell.” The goods enter when you
buy them, and leave when you sell them. So WI is the average “days in inventory.”

“Eventually the firm sells the stuff it made, and gets paid for the stuff it sold.” Now an
accounts receivable ledger flares up on the screen, with entries flowing into this ledger when
the firm sells the stuff, and flowing out when the firm gets paid for what it sold. You think of
this average flow rate as S (the “S” stands for sales, since receivables enter the ledger when
you book a sale). You envision the average dollar balance of the ledger as LS, and realize the
average length of time an entry stays in the ledger, WS, is WS = LS / S. This length of time,
WS, is time between the points “sell” and “get paid,” representing the average number of days
that sales are outstanding.

Now the balance sheet and income statement come into focus. Since the balance sheet gives
you a SNAPSHOT, it must give you LP, LI and LS. Since the income statement gives you
flow rates, it must give you P, I and S. The question is, what specific ENTRIES in the
balance sheet and income statement should you use?

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LS and S are easy, you conclude. There is a “Receivables” entry on the balance sheet under
“Current assets” that corresponds to LS. The rate at which you sell stuff is given by the
“Sales” item on the income statement, so you readily see this is S. This one’s a slam dunk.

LP and P are intuitive, as well. There is a “Payables” entry on the balance sheet under
“Current liabilities” that you associate with LP. And since the stuff you need to pay for
includes materials that you purchase and operating expenses that you incur, you use
“Operating costs” or a similar entry from the income statement for P. Two down, one to go.

LI and I are also straightforward, now that you have the hang of it. LI is given by the
“Inventories” entry under “Current assets,” while I is taken as the “Cost of goods sold”
(COGS) entry in the income statement. (The rationale here is that a firm attaches a value to
its inventory at this cost. Stated alternately, the COGS entry in the income statement reflects
the total amount of inventory that moved through the firm during the year, where the
inventory is valued not be what the customer ultimately pays for it but by what the firm has
“invested” in the inventory.)

You jump up from your dream, grab Caterpillar’s annual report, and track down the numbers.
Somehow, you realize that the “Condensed Results of Operations” is really the income
statement and the “Condensed Financial Position” is really the balance sheet. (How are you
supposed to know this, you ask? Go ask your accounting prof. How should I know??? I’m
an Operations guy.)

From Cat’s Balance Sheet (millions) From Cat’s Income Statement (millions)
Dec 25, 1999 1999
Accounts Receivable $2,604 Net Sales $19,972
Accounts Payable $3,558 Cost of goods sold (COGS) $15,031
Inventory $2,842 Total operating costs & expenses $17,884

Making a few quick calculations, you enter the numbers on the picture you drew for your
Mom (see picture below). Then you denote a fourth entry by WC (the “C” for “cash”). This is
the one you really wanted, the time between “pay” and “get paid.” Since the TOTAL time
between “buy” and “get paid” is either the sum WI + WS or the sum WP + WC, you realize WI +
WS = WP + WC which can be rewritten as WC = WI + WS – WP. For Caterpillar:

WP = LP / P = [$3,558 million / ($17,884 million / yr)] (365 days / yr) = 72.6 days.
WS = LS / S = [$2,604 million / ($19,972 million / yr)] (365 days / yr) = 47.6 days.
WI = LI / I = [$2,842 million / ($15,031 million / yr)] (365 days / yr) = 69.0 days.
WC = WI + WS – WP = 69.0 days + 47.6 days – 72.6 days = 44.0 days.

Noting that Cat’s time between “buy” and “sell” is actually shorter than the time between
“buy” and “pay,” you realize Cat’s sequence of events is NOT really “buy,” “pay,” “sell,” and
“get paid,” as you originally drew the timeline, but rather it is “buy,” “sell,” “pay,” and “get
paid,” and you modify Cat’s timeline accordingly.

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 Cat’s Cash Conversion Cycle: 44 days
WI = Days in WS = Days sales
inventory = 69.0 outstanding = 47.6
Buy (receive)

Sell (ship)

Get paid
Pay
WP = Days payment WC = Cash conversion
outstanding = 72.6 cycle = 44.0 days

But before e-mailing the results to her, you have a disconcerting thought. What about this
assumption that LP and LS and LI represent the average number of items in the system? Take
LI, for example. How do we know this is the average inventory level throughout the year, if
we only measure once, at the end of the year?

The answer must be that we don’t. This is where the firm can “play games” with us. There
are notorious examples where the firm does just that. What if, say, the firm closes its year on
December 31st but ships its inventory out on a truck on December 30th, before taking the
snapshot that becomes its balance sheet? “Amazingly,” for some reason, the trucker never
makes it to her destination, returning the inventory to the firm on, say, January 2nd. The firm
has fooled us for now. But to keep fooling us, it would have to implement this scheme in
increasing magnitude every quarter. This questionable practice will catch up with the firm in
the long run. Unless it truly does have a bang-up succeeding quarter, it will eventually have
to write off its excess inventory at a loss, decimating its financial performance.

Now give your Mom credit. She came up with this idea of calculating the cash flow cycle for
Caterpillar. Since you are going to be selling computers, and not earthmoving equipment,
what if she next asks for the cash flow cycle for a computer company? You decide to
generate some ammo to counter her next punch. You decide Dell is a formidable firm in this
industry, and so, looking up Dell’s latest report, you find the following data for the quarter
ended 10/29/1999:

Balance Sheet on 10/29/99 (millions) Dell’s Quarterly Income Statement (millions)

Accounts Receivable $2,827 Net Sales $6,784
Accounts Payable $3,636 Cost of goods sold $5,414
Inventories $374 Total operating costs & expenses $6,328

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Based on this new information, what should you tell your Mom? Draw the picture for Dell’s
cash flow cycle, and determine the number of days that you are going to need Mom’s money.
What is the implication for the loan that you need from your Mother?

While contemplating all of this, you get an e-mail from your Mom. It’s hard to stay a step
ahead of her – she just read an article where Michael Dell claimed that it’s better to measure
“how fast it’s moving” than “how much there is.” She wants to know what this means.

You realize that the “it” that Michael Dell is referring to must be inventory. “How much
there is” must be L. But how do you measure “how fast it’s moving?” That sounds like a
rate, again, since it infers the measure is per unit of time. You recall from your Operation’s
lesson that the service rate is the inverse of the service time, and that the arrival rate is the
inverse of the inter-arrival time. That is, if you see 10 arrivals per hour on average, then on
average, there is 1/10th of an hour between arrivals. Or, if each service takes 1/20th of an hour
on average, then you can do 20 services per hour on average. So times between arrivals and
services are inverses of the rates of arrivals and services, respectively. Accordingly, you
realize that if the TIME a “block” of inventory stays in Cat’s system is 69 days, or 0.19 years,
on average, then the RATE that blocks of inventory move through Cat’s system must be the
inverse, equal to 1 / (69 days) or 1 / (0.19 years) which calculates out to be 0.014 per day or
5.3 per year. Since you like to visualize your results, you draw the following picture, showing
that if the inventory stays in the system 69 days, on average, then blocks of inventory are
“turned over” 5.3 times per year (“how fast it’s moving” is 5.3 turns per year). Of course, you
realize that your picture is merely a representation, since inventory is not really bought and
sold all at one time in “blocks” as your picture infers.

Cat’s Inventory Turnover: 5.3 turns / yr

Inventory turnover = 1 / W = 1 / 69 days = 0.0145 / day

WI = WI = WI =
End of year

69 days 69 days 69 days

Buy

Sell

Buy

Buy
Sell

Sell
Buy

Buy

Buy
Sell

Sell

Sell
Start of year

WI = WI = WI =
69 days 69 days 69 days

You want to impress your Mom, so you tackle the final question. Is Michael Dell correct? Is
it better to measure “how fast it’s moving” than “how much there is?” (YOU decide!
Assume the sales rate, , is constant, and see whether reducing L or increasing 1 / W is better.)