Inventory often is the largest of a company’s assets. But how liquid is this asset? How quickly will it be converted into cash? As’ a step toward answering these questions. short-term creditors often ‘compute the inventory turnover rate.
Inventory Turnover Rate
The inventory turnover rate is equal to the cost of goods sold divided by the average amount of inventory (beginning inventory plus ending inventory, divided by 2). This ratio indicates how many times in the, course of a year the company is able to sell the .amount of its average inventory. The higher this rate, the more quickly the company sells its inventory
To illustrate, a recent annual report of J.e. Penney shows a cost of goods sold of $10,492 million and average inventory of $2,407 million. The inventory turnover rate for \?cII,ney’s. therefore. is 4.36 to I ($10,492 million -;- $2,407 million). We may compute the number of days required for the company to sell its inventory by dividing 365 days by the turnover rate. Thus J.e. Penney requires 84 days to turn over (sell) the amount of its average inventory (365 days +- 4.36).
Users of financial statements find the inventory turnover rate useful in evaluating the liquidity o~J.he company’s inventory. In addition, managers and independent auditors use this computation to help identify inventory that is not selling well and that may have become obsolete. A declining turnover rate indicates that merchandise is not selling as quickly as it used to.
Most businesses sell merchandise on account. Theref-ore,the sale of inventory often does not provide an immediate source of cash. To determine how quickly inventory is converted into cash, the number of days required to sell tneinvemoiv must be combined with the number of days required to collect the accounts receivable. ‘
The number of days required to collect accounts receivable depends on a company’s accounts receivable turnover rate. This figure is computed by dividing net sales by the’ average accounts receivable. The number of days required to collect these receivables then is determined by dividing 365 days by the turnover rate. Data for the J.e. Penney annual report indicate that the company needed 97 days (on average) to collect its accounts receivable
length of the Operating Cycle
The operating cycle of a merchandising company is the average time period between the purchase of merchandise and the conversion of this merchandise back into cash. In other words, the merchandise acquired as inventory.
gradually is converted into accounts receivable by sale of the goods on account, and these receivables are converted into cash through the process of collection. :
The operating cycle of J.e. Penney was approximately ‘181 days, computed by adding the average 84 days required to sell its inventory and the 97 days required to collect its accounts receivable from .customers. From the viewpoint of short-term creditors. the shorter the operating cycle. the higher the quality of the company’s current assets.
Accounting Methods Can Affect Analytical Ratios
The accounting methods selected by a company may affect the ratios and financial statement subtotals used in evaluating the company’s financial position and the results of .its operations. To illustrate, let us consider the effects of inventory valuation methods on inventory turnover rates.
Assume that during a period of rising prices Alpha Company uses LIFO, whereas Beta Company uses FIFO. In all other respects, the two companies are identical; they have the same size inventories, and they purchase and sell the same quantities of merchandise at the same prices and on the same dates. Thus each company physically turns over its inventory at exactly the same rate.
Because Alpha uses the LIFO method, however, its inventory is valued at older (and lower) costs than is the inventory of Beta Company. Also, Alpha’s cost of goods sold includes more recent (and higher) costs than does Beta’s. When these amounts are used
in computing the inventory turnover rate (cost of goods sold divided by average inventory),
Alpha appears to have the higher turnover rate.
We already have stated that the inventories of these two companies are turning over at exactly the same rate. Therefore, the differences in the turnover rates computed from the companies’ financial statements are caused solely by the different accounting methods used in the valuation of the companies’ inventories.
Inventory turnover is not the only ratio that will be affected. Alpha will report lower current assets than Beta and. therefore. a lower current ratio and less working capital. In addition. using LIFO will cause Alpha to report less gross profit and lower net income than Beta.
Comparing LIFO and FIFO Inventories
A LIFO reserve indicates that the company’s inventory is undervalued in terins of its current replacement cost and in terms of the valuation that would have resulted from use of the FIFO method. Thus the inventories . of companies using LIFO are not directly comparable to those of companies using FIFO. Fortunately, this problem is solved in the notes to the. financial statements: Companies using LIFO disclose the-current replacement cost (or FIFO cost) of their inventories.
Liquidation of a LIFO Reserve
The existence of a LIFO reserve :nay cause a company’s profits to rise dramatically if inventory falls to an abnormally low level at year-end. As the company reduces its inventories, the costs transferred to the cost of goods sold will come from older-c-and lower-cost layers. The inclusion of-these old and low costs in . the cost of goods sold can cause the company’s gross profit rate to soar. This situation is called a “liquidation” of a LIFO reserve.
Users of financial statements should recognize that the abnormal profits that result from the liquidation of a LIFO reserve’ do not represent an improvement in financial performance. Rather: these profits are a one-time occurrence, resulting from old and relatively low unit costs temporarily being used in measuring the cost of goods sold.
Users of financial statements easily can determine whether a company’s reported earnings are affected by the liquidation of a LIFO reserve. This liquidation occurs whenever a company using LIFO ends its fiscal year with its inventory at a substantially lower level than at the beginning of the year. If material in dollar amount, the financial impact of this liquidation should be disclosed in notes accompanying the financial statements.
Assessing the Income Tax Benefits of Using LIFO
A LIFO reserve represents the amount by which a company has reduced its taxable income over the years through use of the LIFO method. Referring to our Case in Point, General Motors has reduced its. taxable income (over a long span of years) by more than $2.4 billion. If we assume that ‘GM pays income taxes at a rate of, say, 33%, using LIFO has saved the company about $800 million in income taxes .