Question

In: Accounting

If a company were having inventory problems (producing too many items), how would it affect their...

If a company were having inventory problems (producing too many items), how would it affect their financial statements? Would there be any negative or positive finanical impacts?

Solutions

Expert Solution

* In accounting, inventory represents a company's raw materials, work in progress and finished products. Financial professionals use a wide variety of quantitative and qualitative techniques to understand inventory in their investing analyses. Quantitative techniques involve performing ratio analysis of the inventory by calculating ratios using financial statements. Qualitative analysis includes inspecting notes to financial statements to check inventory valuation methodology and its consistency, researching inventory valuation methods used by competitors and comparing them to the method used by the company.

The days inventory outstanding ratio is calculated as inventory divided by cost of goods sold (COGS) times 365. This ratio measures the average number of days a company holds inventory before selling it. This ratio widely varies across industries and is most helpful when compared against a company's peers. If the ratio increases over time and is much higher compared to its peers, this can be a red flag that the company is struggling to clear its inventory. Holding unsold inventory is costly, because money is tied up in an idle resource with no income until the inventory is sold. It is costly to store inventory, especially when it requires special handling. Also, certain inventory gets obsolete and may require selling at a significant discount just to get rid of it.

Inventory turnover is calculated as the ratio of COGS to average inventory. Sometimes revenues are substituted for COGS and average inventory balance is used. Inventory turnover is especially important for companies that carry physical inventory and indicates how many times inventory balance is sold during the year. Similarly to the days inventory outstanding ratio, inventory turnover should be compared with company's peers due to differences across industries. A low and declining turnover is a negative factor; products tend to deteriorate and lose their value over time.

Inventory to sales ratio is calculated as the ratio of inventory to revenue. Some analysts use an average inventory balance. An increase in this ratio can indicate a company's investment in inventory is growing quicker than its sales or sales are decreasing. On the other hand, if this ratio decreases, it can mean that a company's investment in inventory is decreasing in relation to revenues or revenues are growing. The inventory to sales ratio provides a big picture on the balance sheet and can indicate whether a more thorough analysis of inventory is needed.

In addition to ratio analysis, reading notes to financial statements is helpful in inventory analysis. Because the U.S. generally accepted accounting principles (GAAP) allow different valuation methods for inventory (LIFO, FIFO and average cost), a company's management can use this discretion to manipulate its earnings. Look for any changes in accounting policies related to inventory. Frequent and unjustified changes to inventory valuation methods can indicate earnings management. Also, comparing a company's inventory valuation methodology with that of its peers can provide a common sense check on whether the company's management is being aggressive with inventory valuation. Finally, look for any inventory charges, as they can pinpoint inventory obsolescence problems.

-Based on the above provided facts inventory can either have positive/negative impact on financial statements.


Related Solutions

Discuss the concept of Economic Order Quantity? If a company has too many items in inventory,...
Discuss the concept of Economic Order Quantity? If a company has too many items in inventory, how would this affect its cash flow. What are some of the ways you would maintain an efficient inventory without running out of items for your customers?
20 Items were randomly selected from a large inventory. If 10% of the items in the...
20 Items were randomly selected from a large inventory. If 10% of the items in the inventory are made in Asia, 1. What is the probability that exactly 4 of the 20 items selected are made in Asia? (2 Points) 2. What is the probability that at most 4 of the 20 items selected are made in Asia? (2 Points)
The inventory on hand at the end of 2019 for Reddall Company is valued at a cost of $95,000. The following items were not included in this inventory:
Valuation of InventoryThe inventory on hand at the end of 2019 for Reddall Company is valued at a cost of $95,000. The following items were not included in this inventory:1. Purchased goods in transit, under terms FOB shipping point, invoice price $4,200, freight costs $200.2. Goods out on consignment to Marlman Company, sales price $5,600, shipping costs of $200.3. Goods sold to Grina Co. under terms FOB destination, invoiced for $1,900 which included $178 freight charges to deliver the goods....
If aspirin were taken in a syrup instead of a tablet, how would this affect an...
If aspirin were taken in a syrup instead of a tablet, how would this affect an excipient analysis? Specifically, what result would you expect from the IKI test?
Federal Reserves if the the Federal Rate fund were to increase how would it affect the...
Federal Reserves if the the Federal Rate fund were to increase how would it affect the supply and demand ?
Question 1 How would a sale of $400 of inventory on credit affect the balance sheet...
Question 1 How would a sale of $400 of inventory on credit affect the balance sheet if the cost of the inventory sold was $160? It would increase noncash assets by $400 and increase equity by $400 It would decrease noncash assets by $160 and decrease equity by $160 It would increase cash by $400 and increase equity by $400 Both the first and the second choices, above happen simultaneously Question 2 How would a purchase of inventory on credit...
Hi, I am having a little difficulty understanding how an auditor would test the Inventory and...
Hi, I am having a little difficulty understanding how an auditor would test the Inventory and Warehousing Cycle. What is the difference (Audit Objectives) between substantive tests of transactions for inventory and tests of balances for inventory? How would an auditor use the transaction related objectives to perform Substantive tests of transactions in Inventory? How would that differ from Tests of Details of balances (balance related objectives) in inventory with examples? Thank you so much as I am a little...
GRAVIMETRIC ANALYSIS OF A PHOSPHORUS-CONTAINING FERTILIZER 1. How would adding too little MgSO4 solution affect your...
GRAVIMETRIC ANALYSIS OF A PHOSPHORUS-CONTAINING FERTILIZER 1. How would adding too little MgSO4 solution affect your results? Explain. 2. If the solution is too basic (too much ammonia is added), there is the possibility of forming magnesium hydroxide. How would this affect your results (you may want to consult the solubility rules)? Explain.
How would low air pressure affect the function of the cochlea? How would this affect a...
How would low air pressure affect the function of the cochlea? How would this affect a sense of audition?
1. How would it affect organisms living in cold climates if oil or alcohol were their...
1. How would it affect organisms living in cold climates if oil or alcohol were their main body fluid? 2. How do you think the cohesive nature of water relates to its evaporation? 3. Describe in detail an experiment you could conduct to test whether another substance could replace water.
ADVERTISEMENT
ADVERTISEMENT
ADVERTISEMENT