Chapter 7, Problem 7.21EX

(a)

To determine

Liquidity ratios: Liquidity explains the extent of cash’s nearness to assets and liabilities. It explains how easily assets can be converted into cash. Following are the types of ratios that help to find liquidity position of a company.

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 WF

Answer to Problem 7.21EX

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

$\begin{array}{c}\text{Inventory turnover}=\frac{\text{Cost of goods sold}}{\text{Average inventory}}\\ =\frac{\$85,512}{5,669.50\left(1\right)}\\ =15.08\text{ Times}\end{array}$

Working notes:

The average inventory is calculated as follows:

$\begin{array}{c}\text{Average inventory}=\frac{\left(\begin{array}{l}\text{Inventory, beginning of the year + }\\ \text{Inventory, end of the year}\end{array}\right)}{2}\\ =\frac{\left(5,688+5,651\right)}{2}\\ =5,669.50\end{array}$ (1)

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

$\begin{array}{c}\text{Inventory turnover}=\frac{\text{Cost of goods sold}}{\text{Average inventory}}\\ =\frac{\$2,541}{154\left(2\right)}\\ =16.5\text{ Times}\end{array}$

Working notes:

The average inventory is calculated as follows:

$\begin{array}{c}\text{Average inventory}=\frac{\left(\begin{array}{l}\text{Inventory, beginning of the year + }\\ \text{Inventory, end of the year}\end{array}\right)}{2}\\ =\frac{\left(165+143\right)}{2}\\ =154\end{array}$ (2)

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

$\begin{array}{c}\text{Inventory turnover}=\frac{\text{Cost of goods sold}}{\text{Average inventory}}\\ =\frac{\$9,973}{470.5\left(3\right)}\\ =21.20\text{ Times}\end{array}$

Working notes:

The average inventory is calculated as follows:

$\begin{array}{c}\text{Average inventory}=\frac{\left(\begin{array}{l}\text{Inventory, beginning of the year + }\\ \text{Inventory, end of the year}\end{array}\right)}{2}\\ =\frac{\left(500+441\right)}{2}\\ =470.50\end{array}$ (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 15.08 Times, the inventory turnover of Company S is 16.5 Times & the inventory turnover of Company WF is 21.20 Times.

(b)

To determine

the Days’ sales in inventory ratio for Company K, Company S and Company WF.

Answer to Problem 7.21EX

The Days’ sale in inventory ratio for Company K is calculated is calculated as follows:

$\begin{array}{c}\text{Days' sales in inventory}=\frac{\text{Days in accounting period}}{\text{Inventory turnover}}\\ =\frac{365}{15.08}\\ =\text{ 24}\text{.2 days}\end{array}$

The Days’ sales in inventory ratio for Company M is calculated are calculated as follows:

$\begin{array}{c}\text{Days' sales in inventory}=\frac{\text{Days in accounting period}}{\text{Inventory turnover}}\\ =\frac{365}{16.50}\\ =\text{ 22}\text{.1 days}\end{array}$

The Days’ sales in inventory ratio for Company WF is calculated are calculated as follows:

$\begin{array}{c}\text{Days' sales in inventory}=\frac{\text{Days in accounting period}}{\text{Inventory turnover}}\\ =\frac{365}{21.20}\\ =\text{ 17}\text{.2 days}\end{array}$

Explanation of Solution

The Days’ sales in inventory ratio are calculated by dividing days in accounting period by inventory turnover ratio. The Days’ sale in inventory ratio is an important measure to know how long the company is holding the inventory before selling when compared to its peers.

Conclusion

The Days’ sales in inventory of Company K is 24.2 days, the Days’ sales in inventory of Company S is 22.1 days, & the Days’ sales in inventory of Company WF is 17.2 days.

(c)

To determine

To interpret: the above calculated ratios.

Explanation of Solution

The inventory turnover ratio and days’ sales in inventory are similar for both the companies K and S. Company WF has higher inventory turnover and lower days’ sales in inventory than both the companies K and S. Higher turnover ratio indicates that more value of sales is being generated in the accounting period. It shows that Company K and S are less efficient than company WF in inventory management.

(d)

To determine

To state: the additional cash flow that would be generated if company K had company WF’s days’ sales in inventory.

Explanation of Solution

If company K had matched company WF’s Days’ sales in inventory, then the ending inventory is as follows:

$\begin{array}{c}Days\text{'}s\text{ales in inventory = }\frac{\text{Average inventory}}{\text{Cost of merchandise sold}}\times 365\\ 17.2days=\frac{X}{\$85,512}\times 365\\ X=17.2\times \frac{\$85,512}{365}\\ =\$4,030\end{array}$

The notional average inventory is calculated to be $4,030.

Therefore, the additional cash flow that would been generated is calculated as follows:

	Amount in million ($)
Actual average inventory	5,567
Less: Notional average inventory	4,030
Positive Cash flow	1,640

Conclusion

The additional cash flow that would be generated is $1,640.