Chapter 6, Problem 6.21EX

(a)

To determine

Inventory turnover ratio: Inventory turnover ratio is used to determine the number of times inventory used or sold during the particular accounting period. The formula to calculate the inventory turnover ratio is as follows:

$\text{Inventory turnover}=\frac{\text{Cost of goods sold}}{\text{Average inventory}}$

Days’ sales in inventory: Days’ sales in inventory are used to determine number of days a particular company takes to make sales of the inventory available with them. The formula to calculate the days’ sales in inventory ratio is as follows:

$\text{Days' sales in inventory}=\frac{\text{Days in accounting period}}{\text{Inventory turnover}}$

To determine: the inventory turnover for Company K, Company S and Company W

Answer to Problem 6.21EX

• The inventory turnover ratio for Company K is calculated is calculated as follows:

$\begin{array}{c}\text{Inventory turnover}=\frac{\text{Cost of goods sold}}{\text{Average inventory}}\\ =\frac{\$71,494}{5,040\left(1\right)}\\ =14.2\text{ Times}\end{array}$

Working notes:

The average inventory is calculated as follows:

$\begin{array}{c}\text{Average inventory}=\frac{\left(\begin{array}{l}\text{Inventory, beginning of the year + }\\ \text{Inventory, end of the year}\end{array}\right)}{2}\\ =\frac{\left(5,114+4,966\right)}{2}\\ =5,040\end{array}$ (1)

The inventory turnover ratio for Company S is calculated is calculated as follows:

$\begin{array}{c}\text{Inventory turnover}=\frac{\text{Cost of goods sold}}{\text{Average inventory}}\\ =\frac{\$31,837}{2,546.5\left(2\right)}\\ =12.5\text{ Times}\end{array}$

Working notes:

The average inventory is calculated as follows:

$\begin{array}{c}\text{Average inventory}=\frac{\left(\begin{array}{l}\text{Inventory, beginning of the year + }\\ \text{Inventory, end of the year}\end{array}\right)}{2}\\ =\frac{\left(2,470+2,623\right)}{2}\\ =2,546.5\end{array}$ (2)

The inventory turnover ratio for Company W is calculated is calculated as follows:

$\begin{array}{c}\text{Inventory turnover}=\frac{\text{Cost of goods sold}}{\text{Average inventory}}\\ =\frac{\$11,699}{355.5\left(3\right)}\\ =32.9\text{Times}\end{array}$

Working notes:

The average inventory is calculated as follows:

$\begin{array}{c}\text{Average inventory}=\frac{\left(\begin{array}{l}\text{Inventory, beginning of the year + }\\ \text{Inventory, end of the year}\end{array}\right)}{2}\\ =\frac{\left(374+337\right)}{2}\\ =355.5\end{array}$ (3)

Explanation of Solution

The inventory turnover ratio is calculated by dividing cost of goods sold by average inventory during the period. The average inventory is calculating by dividing beginning inventory and ending inventory by 2. The inventory turnover ratio is an important measure as to how efficient is the management is good at managing inventory and achieving sales from it.

Conclusion

The inventory turnover of Company K is 14.2 Times, the inventory turnover of Company S is 12.5 Times & the inventory turnover of Company W is 32.9 Times.

(b)

To determine

To interpret: the above calculated ratios.

Explanation of Solution

The inventory turnover ratio and number of days’ sales in inventory of Company K and Company S are relatively same. But Company W has a higher inventory turnover ratio and lower number of days’ sales in inventory than the other two companies. Therefore, Company W is efficient in managing inventory than Company K and Company S.

(c)

To determine

The amount of cash flow that would have been generated if Company K had Company W’s number of day’s sales in inventory.

Explanation of Solution

The ending inventory (when Company K had Company W’s number of day’s sales in inventory) is determined as follows:

$\text{Number of Days' sales in inventory =}\frac{\text{Average Inventory}}{\frac{\text{Cost of goods sold}}{\text{365}}}$

$\text{ 11 days =}\frac{\text{X}}{\frac{\text{\$71,494}}{\text{365}}}$

$\begin{array}{c}\text{ X =11}\times \frac{\$71,494}{365}\\ =\$2,154.9\end{array}$

The additional cash flow (in millions) is determined as follows:

Actual average inventory	$5,040.0
Less: Hypothetical average inventory	2,154.9
Positive cash flow potential	$2,885.1

Table (1)

Conclusion

Therefore, $2,155 is the amount of cash flow that would have been generated.