Question

Creditors would prefer a firm to have

1.       inventory turnover of 3.0

2.        Inventory turnover of 2.0

3.       Times-interest-earned of 3.0

4.       Times-interest earned of 5.0

a.       1 and 3

b.       1 and 4

c.        2 and 3

d.        2 and 4

Answer 1

The answer is option B. 1 and 4.

The inventory turnover ratio is an efficiency ratio that shows how effectively inventory is managed by comparing cost of goods sold with average inventory for a period. This measures how many times average inventory is “turned” or sold during a period. In other words, it measures how many times a company sold its total average inventory dollar amount during the year. In general a ratio between 3 and 6 usually means that the rate at which you restock items is well balanced with your sales.

The times interest earned (TIE) ratio is a measure of a company's ability to meet its debt obligations based on its current income. The formula for a company's TIE number is earnings before interest and taxes (EBIT) divided by the total interest payable on bonds and other debt. From an investor or creditor's perspective, an organization that has a times interest earned ratio greater than 2.5 is considered an acceptable risk.

Creditors are particularly interested in this because inventory is often put up as collateral for loans. Banks want to know that this inventory will be easy to sell.