Accounting: The Language of Business - Vol. 1 (Part 104)

Accounting is a big subject and there are huge forces in play. The entire momentum of existing thinking and existing custom is in a direction that allows terrible follies to happen, and the terrible follies have terrible consequences.

– Charlie Munger

Financial Statement Analysis (Part D)

by

Charles Lamson

Inventory Analysis

A business should keep enough inventory on hand to meet the needs of its customers and its operations. At the same time, however, an excessive amount of inventory reduces solvency by tying up funds. Excess inventories also increase insurance expense, property taxes, storage costs, and other related expenses. These expenses further reduce funds that could be used elsewhere to improve operations. Finally, excess inventory also increases the risk of losses because of price declines or obsolescence of the inventory. Two measures that are useful for evaluating the management of inventory are the inventory turnover and the number of days sales in inventory.

Inventory Turnover

The relationship between the volume of goods (merchandise) sold and inventory may be stated as the inventory turnover. It is computed by dividing the cost of goods sold by the average inventory. If monthly data are not available, the average of the inventories at the beginning and the end of the year may be used. The inventory turnover for Lincoln Company is computed as follows:

The inventory turnover improved for Lincoln Company because of an increase in the cost of goods sold and a decrease in the average inventories. Differences across inventories, companies, and industries are too great to allow a general statement on what is good inventory turnover. For example, a firm selling food should have a higher turnover than a firm selling furniture or jewelry. Likewise, the perishable foods department of a supermarket should have a higher turnover than the soaps and cleansers department. However, for each business or each department within a business, there is a reasonable turnover rate. A turnover lower than this rate could mean that inventory is not being managed properly. 

Number of Days' Sales in Inventory

Another measure of the relationship between the cost of goods sold and inventory is the number of days' sales in inventory. This measure is computed by dividing the inventory at the end of the year by the average daily cost of goods sold (cost of goods sold divided by 365). The number of days' sales in inventory for Lincoln company is computed as follows:

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. For Lincoln Company, there is a major improvement in the number of days' sales in inventory during 2023. However, a comparison with earlier years and similar firms would be useful in assessing Lincoln Company's overall inventory management.

Rate of Fixed Assets to Long-Term Liabilities

Long-term notes and bonds are often secured by mortgages on fixed assets. The ratio of fixed assets to long-term liabilities is a solvency measure that indicates the margin of safety of the noteholders or bondholders. It also indicates the ability of the business to borrow additional funds on a long-term basis. The ratio of fixed assets to long-term liabilities for Lincoln Company is as follows:

The major increase in this ratio at the end of 2023 is mainly due to liquidating 1/2 of Lincoln Company's long-term liabilities. If the company needs to borrow additional funds on a long-term basis in the future, it is in a strong position to do so.

Ratio of Liabilities to Stockholders' Equity

Claims against the total assets of a business are divided into two groups: (1) claims of creditors and (2) claims of owners. The relationship between the total claims of the creditors and owners---the ratio of liabilities to stockholders' equity is a solvency measure that indicates the margin of safety for creditors. It also indicates the ability of the business to withstand adverse business conditions. When the claims of creditors are large in relation to the equity of the stockholders, there are usually significant interest payments. If earnings decline to the point where the company is unable to meet its interest payments, the business may be taken over by the creditors.

EXHIBIT 5 Comparative Balance Sheet---Vertical Analysis

The relationship between creditor and stockholder equity is shown in the vertical analysis of the balance sheet. For example, the balance sheet of Lincoln Company in Exhibit 5, from part 101 and reintroduced above, indicates that on December 31, 2023, liabilities represented 27.2% and stockholders' equity represented 72.8% of the total liabilities and stockholders' equity (100.0 %). Instead of expressing each item as a percent of the total, this relationship may be expressed as a ratio of one to the other, as follows:

The balance sheet of Lincoln Company shows that the major factor affecting the change in the ratio was the $100,000 decrease in long-term liabilities during 2023. The ratio at the end of both years shows a large margin of safety for the creditors.

Number of Times Interest Charges are Earned

Corporations in some Industries, such as airlines, normally have high ratios of debt to stockholders equity. For such corporations, the relative risk of the debt holders is normally measured as the number of times interest charges are earned, sometimes called the fixed charge coverage ratio, during the year. The higher the ratio the lower the risk that interest payments will not be made if earnings decrease. In other words, the higher the ratio the greater the assurance that interest payments will be made on a continuing basis. This measure also indicates the general financial strength of the business, which is of interest to stockholders and employees as well as creditors.

The amount available to meet interest charges is not affected by taxes on income. This is because interest is deductible in determining taxable income. Thus, the number of times interest charges are earned is computed as shown below.

Analysis such as this can also be applied to dividends on preferred stock. In such a case, net income is divided by the amount of preferred dividends to yield the number of times preferred dividends are earned. This measure indicates the risk that dividends to preferred stockholders may not be paid. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 700-703*

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