H calculate and interpret ratios used to evaluate inventory management. Flashcards
calculate and interpret ratios used to evaluate inventory management. 'Evaluation of Inventory Management'
Items Impacted: FS items, Financial Ratios (…by the choice of inventory valuation methods)
FS Items: “cost of sales, gross profit, net income, inventories, current assets, and total assets”
Fin. Ratios: “current ratio, return on assets, gross profit margin, and inventory turnover are impacted”
These additionaly impact FS items and Fin. Ratis.
“impacted by adjustments of inventory carrying amounts to net realisable value or current replacement cost.”
These ratios are directly impacted by a company’s choice of inventory valuation method
Inventory Turnover
Days of Inventory on Hand
Gross Profit Margin
These ratios are indirectly impacted by a company’s choice of inventory valuation method
“current ratio, because inventory is a component of current assets;”
“return-on-assets ratio, because cost of sales is a key component in deriving net income and inventory is a component of total assets;”
“debt-to-equity ratio, because the cumulative measured net income from the inception of a business is an aggregate component of retained earning”
Inventory Turnover Ratio (and impact by a company’s inventory valuation method)
‘inventory turnover’ measures how quickly a firm is selling or turning over its inventory (Inv. Turnover Ratio aka ‘turns per period’)
“inventory turnover ratio measures the number of times during the year a company sells (i.e., turns over) its inventory.”
Higher: More times that inventory is sold and the lower the relative investment of resources in that inventory
Lower: Less times that inventory is sold and the higher the relative investment of resources in that inventory. Carrying too much inventory is costly: The firm incurs storage costs, insurance, and inventory taxes. Excessive inventory ties up cash that may be used more efficiently elsewhere.
Days of Inventory on Hand (and impact by a company’s inventory valuation method)
“Days of inventory on hand can be calculated as days in the period divided by inventory turnover. “
Gross Profit Margin (and impact by a company’s inventory valuation method)
“The gross profit margin, the ratio of gross profit to sales”…gross profit / sales revenue
Measures the relationship between the unit sale price and the cost per unit sold
Gross Profit Margin Indicates: The % of sales being contributed to NI as opposed to covering the cost of sales
“A company’s gross profit margin may be a function of its type of product”
GP is lower in highly competitive industries as firms experience downward pressure on sales prices
Inv. Turnover Ratio and DOH fact
They’re inversely related
DOH is based on the ending inventory amount
Inv. Turnover Ratio is calculated using average inventory in the year
Inversely related: High Inv. Turnover Ratio means DOH is low
What may indicate highly effective inventory management?…or what could it also indicate?
A high Inv. Turnover Ratio and a low DOH
“could indicate that the company does not carry an adequate amount of inventory or that the company has written down inventory values, in addition that it may indicate highly effective inventory management”
Further High Inv Turnover Ratio, low DOH indications
“A high inventory turnover ratio and a low number of days of inventory on hand might indicate highly effective inventory management. Alternatively, a high inventory ratio and a low number of days of inventory on hand could indicate that the company does not carry an adequate amount of inventory or that the company has written down inventory values. Inventory shortages could potentially result in lost sales or production problems in the case of the raw materials inventory of a manufacturer. To assess which explanation is more likely, analysts can compare the company’s inventory turnover and sales growth rate with those of the industry and review financial statement disclosures. Slower growth combined with higher inventory turnover could indicate inadequate inventory levels. Write-downs of inventory could reflect poor inventory management. Minimal write-downs and sales growth rates at or above the industry’s growth rates would support the interpretation that the higher turnover reflects greater efficiency in managing inventory.”
“A low inventory turnover ratio and a high number of days of inventory on hand relative to industry norms”
“indicator of slow-moving or obsolete inventory.”
Luxury Products, specialty products v. Staple Products
Higher GP margins? Luxury products, specialty products
Higher Inventory Turnover? Staple Products
Inventory Turnover Ratio is too High
May indicate that the firm cannot keep up with demand, which can cause the firm to lose sales
May also indicate that write-downs (losses due to obsolescence, spoilage, losses in value) have occurred which indicates poor inventory management.
Inventory Turnover Relative to Sales Growth
High turnover + Slow growth may = inadequate inventory quantities.
Sales growth at or above industry avg. supports conclusion that high inv. turnover reflects greater efficiency.