Financial Accounting: An Integrated Statements Approach, 2nd Edition

Chapter 6 Inventories 283

Number of Days’ Sales in Inventory

Average Inventory

Average Daily Cost of Merchandise Sold

The average daily cost of merchandise sold is determined by dividing the cost of mer-

chandise sold by 365. The number of days’ sales in inventory for Best Buy and Circuit

City is computed as shown below.

Best Buy Circuit City

Average daily cost of merchandise sold:

$18,350/365 $50.27

$7,904/365 $21.65

Average inventory $2,342 $1,488

Number of days’ sales in inventory 47 days 69 days

Generally, the lower the number of days’ sales in inventory, the better. The number of

days’ sales in inventory confirms the inventory turnover ratio, namely, Best Buy is

managing its inventory more efficiently than is Circuit City. As with inventory turnover,

we should expect differences among industries, such as those for Best Buy and Zale,

whose number of days’ sales in inventory is 243 days.

Inventory ratios can also be used to evaluate inventory performance trends over

time. For example, Best Buy has improved its inventory turnover over the last eight

years from 4.6 turns to 7.8 turns. Best Buy has credited this improvement to quick re-

sponse policies, lower markdowns, and faster-moving product assortments.

Inventories and Cash Flows

If a company increases its inventory balances from period to pe-
riod, then the amount of cash invested in inventory is increas-
ing. In contrast, if the inventory balances are decreasing, cash
is being returned to the business. This is why companies use in-
ventory reduction strategies, such as quick response, in order to
capture one-time cash benefits from reducing inventory. On the
other hand, if management grows inventory in anticipation of
sales that do not materialize, then cash will be used.
The impact of changes in inventory balances is shown in
the operating activities section of the statement of cash flows.
For example, Best Buyreported the following (in millions):

Net income $ 984
Inventory, February 28, 2004 2,611
Inventory, February 26, 2005 2,851

The operating section of the statement of cash flows is re-
produced for Best Buy below, with the shaded area showing
the impact of inventory changes.

(in millions)

For the Fiscal Year Ended Feb. 26, 2005

Operating activities:

Net income $ 984

Depreciation 459

Other adjustments to net income (33)

Changes in operating assets and liabilities:

Receivables (30)

Merchandise inventories (240)

Liabilities 891

Other operating activities (190)

Total cash provided by operating activities $1,841

As you can see, the increase in inventory from $2,611 to

$2,851 is reflected as a use of $240 cash on the statement of

cash flows. Best Buy is a growing business; thus, using cash to

increase inventories would be expected.

FOCUS ON CASH FLOW

Identify the types of inventory used by merchan-
disers and manufacturers. The inventory of a
merchandiser is called merchandise inventory. The cost
of merchandise inventory that is sold is reported on the

income statement. Manufacturers typically have three

types of inventory: materials, work-in-process, and finished

goods. When finished goods are sold, the cost is reported

on the income statement as cost of goods sold.

SUMMARY OF LEARNING GOALS

1