Accounting: The Language of Accounting (Part 56)

“To multiply the years and divide by the desire to live is a kind of false accounting.” —Peter Heller

Inventories (Part H)

by

Charles Lamson

Financial Analysis and Interpretation

A merchandising business should keep enough inventory on hand to meet the needs of its customers. A failure to do so may result in lost sales. At the same time, too much inventory reduces solvency by tying up funds that could be better used to expand or improve operations. In addition, excess inventory increases expenses such as storage, insurance, and property taxes. Finally, excess inventory increases the risk of losses due to price declines, damage, or changes in customers' buying patterns.

As with many types of financial analyses, it is possible to use more than one measure to analyze the efficiency and effectiveness by which a business manages its inventory. Two such measures are the inventory turnover and the number of days' sales in inventory.

Inventory turnover measures the relationship between the volume of goods (merchandise) sold and the amount of inventory carried during the period. It is computed as follows:

Inventory turnover = Cost of merchandise sold / Average inventory

The average inventory can be computed using weekly, monthly, or yearly figures. To simplify, we determine the average inventory by dividing the sum of the inventories at the beginning and end of the year by 2. As long as the amount of inventory carried throughout the year remains stable, this average will be accurate enough for our analysis. 

Generally, the larger the inventory turnover, the more efficient and effective the management of the inventory. However, differences in companies and industries are too great to allow specific statements as to what is a good inventory turnover. As with other financial measures we have discussed, a comparison of a company's inventory turnover over time and with industry averages will provide useful insights into the management of its inventory.

The number of days sales in inventory is a rough measure of the length of time it takes to acquire, sell, and replace the inventory. It is computed as follows:

Number of days sales in inventory = Inventory, end of year / Average daily cost of merchandise sold

The average daily cost of merchandise sold is determined by dividing the cost of merchandise sold by 365. 

Generally, the lower the number of days sales in inventory, the better. As with inventory turnover, we should expect differences among industries. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 371-372*

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