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Principles of Accounting, Volume 1: Financial Accounting

10.5 Examine the Efficiency of Inventory Management Using Financial Ratios

Principles of Accounting, Volume 1: Financial Accounting10.5 Examine the Efficiency of Inventory Management Using Financial Ratios
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  1. Preface
  2. 1 Role of Accounting in Society
    1. Why It Matters
    2. 1.1 Explain the Importance of Accounting and Distinguish between Financial and Managerial Accounting
    3. 1.2 Identify Users of Accounting Information and How They Apply Information
    4. 1.3 Describe Typical Accounting Activities and the Role Accountants Play in Identifying, Recording, and Reporting Financial Activities
    5. 1.4 Explain Why Accounting Is Important to Business Stakeholders
    6. 1.5 Describe the Varied Career Paths Open to Individuals with an Accounting Education
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
  3. 2 Introduction to Financial Statements
    1. Why It Matters
    2. 2.1 Describe the Income Statement, Statement of Owner’s Equity, Balance Sheet, and Statement of Cash Flows, and How They Interrelate
    3. 2.2 Define, Explain, and Provide Examples of Current and Noncurrent Assets, Current and Noncurrent Liabilities, Equity, Revenues, and Expenses
    4. 2.3 Prepare an Income Statement, Statement of Owner’s Equity, and Balance Sheet
    5. Key Terms
    6. Summary
    7. Multiple Choice
    8. Questions
    9. Exercise Set A
    10. Exercise Set B
    11. Problem Set A
    12. Problem Set B
    13. Thought Provokers
  4. 3 Analyzing and Recording Transactions
    1. Why It Matters
    2. 3.1 Describe Principles, Assumptions, and Concepts of Accounting and Their Relationship to Financial Statements
    3. 3.2 Define and Describe the Expanded Accounting Equation and Its Relationship to Analyzing Transactions
    4. 3.3 Define and Describe the Initial Steps in the Accounting Cycle
    5. 3.4 Analyze Business Transactions Using the Accounting Equation and Show the Impact of Business Transactions on Financial Statements
    6. 3.5 Use Journal Entries to Record Transactions and Post to T-Accounts
    7. 3.6 Prepare a Trial Balance
    8. Key Terms
    9. Summary
    10. Multiple Choice
    11. Questions
    12. Exercise Set A
    13. Exercise Set B
    14. Problem Set A
    15. Problem Set B
    16. Thought Provokers
  5. 4 The Adjustment Process
    1. Why It Matters
    2. 4.1 Explain the Concepts and Guidelines Affecting Adjusting Entries
    3. 4.2 Discuss the Adjustment Process and Illustrate Common Types of Adjusting Entries
    4. 4.3 Record and Post the Common Types of Adjusting Entries
    5. 4.4 Use the Ledger Balances to Prepare an Adjusted Trial Balance
    6. 4.5 Prepare Financial Statements Using the Adjusted Trial Balance
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  6. 5 Completing the Accounting Cycle
    1. Why It Matters
    2. 5.1 Describe and Prepare Closing Entries for a Business
    3. 5.2 Prepare a Post-Closing Trial Balance
    4. 5.3 Apply the Results from the Adjusted Trial Balance to Compute Current Ratio and Working Capital Balance, and Explain How These Measures Represent Liquidity
    5. 5.4 Appendix: Complete a Comprehensive Accounting Cycle for a Business
    6. Key Terms
    7. Summary
    8. Multiple Choice
    9. Questions
    10. Exercise Set A
    11. Exercise Set B
    12. Problem Set A
    13. Problem Set B
    14. Thought Provokers
  7. 6 Merchandising Transactions
    1. Why It Matters
    2. 6.1 Compare and Contrast Merchandising versus Service Activities and Transactions
    3. 6.2 Compare and Contrast Perpetual versus Periodic Inventory Systems
    4. 6.3 Analyze and Record Transactions for Merchandise Purchases Using the Perpetual Inventory System
    5. 6.4 Analyze and Record Transactions for the Sale of Merchandise Using the Perpetual Inventory System
    6. 6.5 Discuss and Record Transactions Applying the Two Commonly Used Freight-In Methods
    7. 6.6 Describe and Prepare Multi-Step and Simple Income Statements for Merchandising Companies
    8. 6.7 Appendix: Analyze and Record Transactions for Merchandise Purchases and Sales Using the Periodic Inventory System
    9. Key Terms
    10. Summary
    11. Multiple Choice
    12. Questions
    13. Exercise Set A
    14. Exercise Set B
    15. Problem Set A
    16. Problem Set B
    17. Thought Provokers
  8. 7 Accounting Information Systems
    1. Why It Matters
    2. 7.1 Define and Describe the Components of an Accounting Information System
    3. 7.2 Describe and Explain the Purpose of Special Journals and Their Importance to Stakeholders
    4. 7.3 Analyze and Journalize Transactions Using Special Journals
    5. 7.4 Prepare a Subsidiary Ledger
    6. 7.5 Describe Career Paths Open to Individuals with a Joint Education in Accounting and Information Systems
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  9. 8 Fraud, Internal Controls, and Cash
    1. Why It Matters
    2. 8.1 Analyze Fraud in the Accounting Workplace
    3. 8.2 Define and Explain Internal Controls and Their Purpose within an Organization
    4. 8.3 Describe Internal Controls within an Organization
    5. 8.4 Define the Purpose and Use of a Petty Cash Fund, and Prepare Petty Cash Journal Entries
    6. 8.5 Discuss Management Responsibilities for Maintaining Internal Controls within an Organization
    7. 8.6 Define the Purpose of a Bank Reconciliation, and Prepare a Bank Reconciliation and Its Associated Journal Entries
    8. 8.7 Describe Fraud in Financial Statements and Sarbanes-Oxley Act Requirements
    9. Key Terms
    10. Summary
    11. Multiple Choice
    12. Questions
    13. Exercise Set A
    14. Exercise Set B
    15. Problem Set A
    16. Problem Set B
    17. Thought Provokers
  10. 9 Accounting for Receivables
    1. Why It Matters
    2. 9.1 Explain the Revenue Recognition Principle and How It Relates to Current and Future Sales and Purchase Transactions
    3. 9.2 Account for Uncollectible Accounts Using the Balance Sheet and Income Statement Approaches
    4. 9.3 Determine the Efficiency of Receivables Management Using Financial Ratios
    5. 9.4 Discuss the Role of Accounting for Receivables in Earnings Management
    6. 9.5 Apply Revenue Recognition Principles to Long-Term Projects
    7. 9.6 Explain How Notes Receivable and Accounts Receivable Differ
    8. 9.7 Appendix: Comprehensive Example of Bad Debt Estimation
    9. Key Terms
    10. Summary
    11. Multiple Choice
    12. Questions
    13. Exercise Set A
    14. Exercise Set B
    15. Problem Set A
    16. Problem Set B
    17. Thought Provokers
  11. 10 Inventory
    1. Why It Matters
    2. 10.1 Describe and Demonstrate the Basic Inventory Valuation Methods and Their Cost Flow Assumptions
    3. 10.2 Calculate the Cost of Goods Sold and Ending Inventory Using the Periodic Method
    4. 10.3 Calculate the Cost of Goods Sold and Ending Inventory Using the Perpetual Method
    5. 10.4 Explain and Demonstrate the Impact of Inventory Valuation Errors on the Income Statement and Balance Sheet
    6. 10.5 Examine the Efficiency of Inventory Management Using Financial Ratios
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  12. 11 Long-Term Assets
    1. Why It Matters
    2. 11.1 Distinguish between Tangible and Intangible Assets
    3. 11.2 Analyze and Classify Capitalized Costs versus Expenses
    4. 11.3 Explain and Apply Depreciation Methods to Allocate Capitalized Costs
    5. 11.4 Describe Accounting for Intangible Assets and Record Related Transactions
    6. 11.5 Describe Some Special Issues in Accounting for Long-Term Assets
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  13. 12 Current Liabilities
    1. Why It Matters
    2. 12.1 Identify and Describe Current Liabilities
    3. 12.2 Analyze, Journalize, and Report Current Liabilities
    4. 12.3 Define and Apply Accounting Treatment for Contingent Liabilities
    5. 12.4 Prepare Journal Entries to Record Short-Term Notes Payable
    6. 12.5 Record Transactions Incurred in Preparing Payroll
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  14. 13 Long-Term Liabilities
    1. Why It Matters
    2. 13.1 Explain the Pricing of Long-Term Liabilities
    3. 13.2 Compute Amortization of Long-Term Liabilities Using the Effective-Interest Method
    4. 13.3 Prepare Journal Entries to Reflect the Life Cycle of Bonds
    5. 13.4 Appendix: Special Topics Related to Long-Term Liabilities
    6. Key Terms
    7. Summary
    8. Multiple Choice
    9. Questions
    10. Exercise Set A
    11. Exercise Set B
    12. Problem Set A
    13. Problem Set B
    14. Thought Provokers
  15. 14 Corporation Accounting
    1. Why It Matters
    2. 14.1 Explain the Process of Securing Equity Financing through the Issuance of Stock
    3. 14.2 Analyze and Record Transactions for the Issuance and Repurchase of Stock
    4. 14.3 Record Transactions and the Effects on Financial Statements for Cash Dividends, Property Dividends, Stock Dividends, and Stock Splits
    5. 14.4 Compare and Contrast Owners’ Equity versus Retained Earnings
    6. 14.5 Discuss the Applicability of Earnings per Share as a Method to Measure Performance
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  16. 15 Partnership Accounting
    1. Why It Matters
    2. 15.1 Describe the Advantages and Disadvantages of Organizing as a Partnership
    3. 15.2 Describe How a Partnership Is Created, Including the Associated Journal Entries
    4. 15.3 Compute and Allocate Partners’ Share of Income and Loss
    5. 15.4 Prepare Journal Entries to Record the Admission and Withdrawal of a Partner
    6. 15.5 Discuss and Record Entries for the Dissolution of a Partnership
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  17. 16 Statement of Cash Flows
    1. Why It Matters
    2. 16.1 Explain the Purpose of the Statement of Cash Flows
    3. 16.2 Differentiate between Operating, Investing, and Financing Activities
    4. 16.3 Prepare the Statement of Cash Flows Using the Indirect Method
    5. 16.4 Prepare the Completed Statement of Cash Flows Using the Indirect Method
    6. 16.5 Use Information from the Statement of Cash Flows to Prepare Ratios to Assess Liquidity and Solvency
    7. 16.6 Appendix: Prepare a Completed Statement of Cash Flows Using the Direct Method
    8. Key Terms
    9. Summary
    10. Multiple Choice
    11. Questions
    12. Exercise Set A
    13. Exercise Set B
    14. Problem Set A
    15. Problem Set B
    16. Thought Provokers
  18. Financial Statement Analysis
  19. Time Value of Money
  20. Suggested Resources
  21. Answer Key
    1. Chapter 1
    2. Chapter 2
    3. Chapter 3
    4. Chapter 4
    5. Chapter 5
    6. Chapter 6
    7. Chapter 7
    8. Chapter 8
    9. Chapter 9
    10. Chapter 10
    11. Chapter 11
    12. Chapter 12
    13. Chapter 13
    14. Chapter 14
    15. Chapter 15
    16. Chapter 16
  22. Index

Inventory is a large investment for many companies so it is important that this asset be managed wisely. Too little inventory means lost sales opportunities, whereas too much inventory means unproductive investment of resources as well as extra costs related to storage, care, and protection of the inventory. Ratio analysis is used to measure how well management is doing at maintaining just the right amount of inventory for the needs of their particular business.

Once calculated, these ratios should be compared to previous years’ ratios for the company, direct competitors’ ratios, industry ratios, and other industries’ ratios. The insights gained from the ratio analysis should be used to augment analysis of the general strength and stability of the company, with the full data available in the annual report, including financial statements and notes to the financial statement.

Fundamentals of Inventory Ratios

Inventory ratio analysis relates to how well the inventory is being managed. Two ratios can be used to assess how efficiently management is handling inventory. The first ratio, inventory turnover, measures the number of times an average quantity of inventory was bought and sold during the period. The second ratio, number of days’ sales in inventory, measures how many days it takes to complete the cycle between buying and selling inventory.

Calculating and Interpreting the Inventory Turnover Ratio

Inventory turnover ratio is computed by dividing cost of goods sold by average inventory. The ratio measures the number of times inventory rotated through the sales cycle for the period. Let’s review how this works for The Spy Who Loves You dataset. This example scenario relates to the FIFO periodic cost allocation, using those previously calculated values for year 1 cost of goods sold, beginning inventory, and ending inventory, and assuming a 10% increase in inventory activity for year 2, as shown in Figure 10.24.

Balance Sheet Year 1 has: Beginning Inventory $3,150 plus Purchases 13,005 equals Goods Available for Sale 16,155 minus Ending Inventory 8,955. This equals the Cost of Goods Sold of $7,200 which would be on the Income Statement for Year 1. Balance Sheet Year 2 has: Beginning Inventory $8,955 plus Purchases 8,816 equals Goods Available for Sale 17,771 minus Ending Inventory 9,851. This equals the Cost of Goods Sold of $7,920 which would be on the Income Statement for Year 2. Note: Year 2 values for Sales, Goods Available, and Ending Inventory were estimated, based on 110 percent of Year 1’s amounts.
Figure 10.24 Excerpts from Financial Statements of The Spy Who Loves You Company. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

The inventory turnover ratio is calculated by dividing cost of goods sold by average inventory. The result for the Spy Who Loves You Company indicates that the inventory cycled through the sales cycle 1.19 times in year 1, and 0.84 times in year 2.

Inventory Turnover Ratio calculation for year 1 and 2: Year 1: Cost of Goods Sold $7,200 divided by Average Inventory* 6,053 equals Inventory Turnover of 1.19. Year 2: Cost of Goods Sold $7,920 divided by Average Inventory* 9,403 equals Inventory Turnover of 0.84. *Average Inventory Year 1 equals (3,150 plus 8,955) divided by 2; Average Inventory Year 2 equals (8,955 plus 9,851) divided by 2.

The fact that the year 2 inventory turnover ratio is lower than the year 1 ratio is not a positive trend. This result would alert management that the inventory balance might be too high to be practical for this volume of sales. Comparison should also be made to competitor and industry ratios, while consideration should also be given to other factors affecting the company’s financial health as well as the strength of the overall market economy.

Calculating and Interpreting the Days’ Sales in Inventory Ratio

Number of days’ sales in inventory ratio is computed by dividing average merchandise inventory by the average daily cost of goods sold. The ratio measures the number of days it would take to clear the remaining inventory. Let’s review this using The Spy Who Loves You dataset. The example scenario relates to the FIFO periodic cost allocation, using those previously calculated values for year 1 cost of goods sold, beginning inventory, and ending inventory, and assuming a 10% increase in inventory activity for year 2, as in Figure 10.25.

Balance Sheet Year 1 has: Beginning Inventory $3,150 plus Purchases 13,005 equals Goods Available for Sale 16,155 minus Ending Inventory 8,955. This equals the Cost of Goods Sold of $7,200 which would be on the Income Statement for Year 1. Balance Sheet Year 2 has: Beginning Inventory $8,955 plus Purchases 8,816 equals Goods Available for Sale 17,771 minus Ending Inventory 9,851. This equals the Cost of Goods Sold of $7,920 which would be on the Income Statement for Year 2. Note: Year 2 values for Sales, Goods Available, and Ending Inventory were estimated, based on 110 percent of Year 1’s amounts.
Figure 10.25 Excerpts from Financial Statements of The Spy Who Loves You Company. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

The number of days’ sales in inventory ratio is calculated by dividing average inventory by average daily cost of goods sold. The result for the Spy Who Loves You indicates that it would take about 307 days to clear the average inventory held in year 1 and about 433 days to clear the average inventory held in year 2.

Table showing Number of Day’s Sales in Inventory Ratio calculation: Year 1: Average Inventory* 6,053 divided by Average Daily Cost of Goods Sold** 19.73 equals Days’ Sales in Inventory $306.79. Year 2: Average Inventory* 9,403 divided by Average Daily Cost of Goods Sold** 21.70 equals Days’ Sales in Inventory $433.32. *Average Inventory Year 1 equals (3,150 plus 8,955) divided by 2; Average Inventory Year 2 equals (8,955 plus 9,851) divided by 2. **Average Daily Cost of Goods Sold Year 1 equals (7,200 divided by 365); Average Daily Cost of Goods Sold Year 2 equals (7,920 divided by 365).

Year 2’s number of days’ sales in inventory ratio increased over year 1’s ratio results, indicating an unfavorable change. This result would alert management that it is taking much too long to sell the inventory, so reduction in the inventory balance might be appropriate, or as an alternative, increased sales efforts could turn the ratio toward a more positive trend. This ratio is useful to identify cases of obsolescence, which is especially prevalent in an evolving market, such as the technology sector of the economy. As with any ratio, comparison should also be made to competitor and industry ratios, while consideration should also be given to other factors affecting the company’s financial health, as well as to the strength of the overall market economy.

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