Financial Accounting: An Integrated Statements Approach, 2nd Edition

INVENTORY ANALYSIS AND INTERPRETATION

As with many types of financial analyses, the efficiency and effectiveness of managing

inventory can be analyzed by using more than one measure. Two such measures are

the inventory turnover and the number of days’ sales in inventory.

Inventory turnover(or inventory turns) 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

* For a manufacturing company, the numerator would be Cost of Goods Sold.

We determine the average inventory by dividing the sum of the inventories at the be-

ginning and end of the year by 2. To illustrate, the following data have been taken from

recent annual reports for Best BuyandCircuit City Stores, Inc.(amounts in millions,

except ratio):

Best Buy Circuit City

a. Cost of merchandise sold $18,350 $7,904

Merchandise inventories:

Beginning of year $ 2,077 $1,517

End of year 2,607 1,459

Total $ 4,684 $2,976

b. Average (total2) $ 2,342 $1,488

Inventory turnover (ab) 7.84 5.31

The inventory turnover is 7.84 for Best Buy and 5.31 for

Circuit City. That is, for every dollar of inventory, Best Buy

is able to support $7.84 of cost of merchandise sold. Thus, a

larger inventory turnover is associated with more efficient

and effective management of the inventory. It appears that

Best Buy is achieving greater inventory efficiency than is

Circuit City. Best Buy’s management explains its inventory

efficiency efforts as follows:

By working more closely with our suppliers, we expect to

reduce inefficiencies while creating more flexibility for

responding to customer needs. As a result, we hope to

ensure that we have the right product at the right loca-

tion at the right time. Thus, we expect to improve our in-

stock percentage, customer satisfaction, inventory turns

and overall profitability.

Differences in companies and industries are too great to allow specific statements as

to what is a good inventory turnover. For example, Zale Corporation, a jewelry re-

tailer, had a recent inventory turnover ratio of 1.38, which is slower than the inventory

turnover of an electronics retailer. Such a difference would be expected, since jewelry

is not subject to the same obsolescence as are consumer electronic products.

Thenumber of days’ sales in inventoryapproximates the length of time it takes

to acquire, sell, and replace the inventory. It is computed as follows:

282 Chapter 6 Inventories

Determine and interpret

the inventory turnover

ratio and the number of

days’ sales in inventory.

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