Efficiency ratios for inventory measure how effectively a business uses its inventory resources.
Describe how a company uses efficiency metrics to monitor inventory
- An efficiency metric or ratio, sometimes referred to as an activity ratio, is a type of financial ratio. The inventory turnover rate is a type of efficiency metric.
- Financial ratios evaluate the overall financial condition of a corporation or other organization in comparison to its industry and competitors.
- A low inventory turnover rate may point to overstocking, obsolescence, or deficiencies in the product line or marketing effort.
- A high turnover rate may indicate inadequate inventory levels, which may lead to a loss in business as the inventory is too low.
- Cost of Goods Sold: refers to the inventory costs of the goods a business has sold during a particular period (sometimes abbreviated as COGS).
- obsolescence: The process of becoming obsolete, outmoded, or out of date.
Efficiency Metrics (Ratios)
An efficiency metric or ratio, sometimes referred to as an activity ratio, is a type of financial ratio. Management, financial analysts, and the investment community evaluate financial ratios when trying to evaluate the overall financial condition of a corporation or other organization. Ratios can be expressed as a decimal value, such as 0.10, or given as an equivalent percent value, such as 10%. Some ratios are usually quoted as percentages, especially ratios that are usually or always less than 1, while others are usually quoted as decimal numbers, especially ratios that are usually more than 1. Efficiency ratios for inventory are used to measure how effectively a business uses its inventory resources in comparison to its industry or competitors.
It’s important for organizations to strike the right balance on their inventory levels. If inventory levels are too low, the company runs the risk of losing out on sales and not meeting customer demand. This can lead customers to give their business to the company’s competitors. When there is excess inventory, a company can have higher operating costs due to greater inventory storage requirements, which will decrease profits. In addition, excess inventory increases the risk of losses due to price declines or inventory obsolescence.
Types of Efficiency Metrics (Ratios)
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory (to calculate average inventory, add the balances of beginning and ending inventory and divide by 2)
The inventory turnover ratio is a measure of the number of times inventory is sold or used in a time period, such as a year. A low turnover rate may point to overstocking, obsolescence, or deficiencies in the product line or marketing effort. A high turnover rate may indicate inadequate inventory levels, which may lead to a loss in business as the inventory is too low.
Inventory Conversion Ratio = 365 Days / Inventory Turnover Ratio
The inventory conversion ratio is a measure of the number of days in a year it takes to sell inventory or convert it into cash.
Impact of Inventory Method on Financial Statement Analysis
The inventory method chosen will affect the amount of current assets and gross profit income statement, especially when prices are changing.
Explain how a company’s choice of inventory method affects their financial statements
- There are five types of inventory methods — FIFO, LIFO, Dollar Value LIFO, Retail Inventory, and Average Cost.
- The choice of inventory method should reflect a company’s economic circumstances in order to create accurate financial statements.
- When prices are falling, FIFO will result in lower current assets and lower gross profit. LIFO will result in higher current assets and higher gross profit.
- When prices are rising, FIFO will result in higher current assets and higher gross profit. LIFO will result in lower current assets and lower gross profit.
- balance sheet: A balance sheet is often described as a “snapshot of a company’s financial condition. ” A standard company balance sheet has three parts: assets, liabilities, and ownership equity.
- income statement: Displays the revenues recognized for a specific period and the cost and expenses charged against these revenues, including write-offs (e.g., depreciation and amortization of various assets) and taxes. The purpose of the income statement is to show managers and investors whether the company made or lost money during the reporting period.
Types of Inventory Methods
Inventories are valued in the “Current Assets” section of the balance sheet using one of the following five methods. It’s important to note that these methods will be affected by the system used to update inventory – ” perpetual ” or “periodic”. A perpetual system updates inventory every time a change in inventory occurs, and a periodic system updates inventory at the end of the accounting period.
First-In First-Out (FIFO) assumes that the items purchased or produced first are sold first. Costs of inventory per unit or item are determined at the time made or acquired. The oldest cost (i.e., the first in) is then matched against revenue and assigned to cost of goods sold. The ending inventory balance reflects recent inventory costs.
Last-In First-Out (LIFO) is the reverse of FIFO; the latest cost (i.e., the last in) is assigned to cost of goods sold and matched against revenue. Some systems permit determining the costs of goods at the time acquired or made but assigning costs to goods sold under the assumption that the goods made or acquired last are sold first. Costs of specific goods acquired or made are added to a pool of costs for the type of goods. Under this system, the business may maintain costs under FIFO but track an offset in the form of a LIFO reserve. The LIFO reserve (an asset or contra-asset) represents the difference in cost of inventory under the FIFO and LIFO assumptions. Such amount may be different for financial reporting and tax purposes in the United States.
Dollar Value LIFO is a variation of LIFO. Any increases or decreases in the LIFO reserve are determined based on dollar values rather than quantities.
The Retail Inventory method is typically used by resellers of goods to simplify record keeping. The calculated cost of goods on hand at the end of a period is the ratio of cost of goods acquired to the retail value of the goods times the retail value of goods on hand. Cost of goods acquired includes beginning inventory as previously valued plus purchases. Cost of goods sold is then beginning inventory plus purchases less the calculated cost of goods on hand at the end of the period.
The Average Cost method relies on average unit cost to calculate cost of goods sold and ending inventory. Several variations on the calculation may be used, including weighted average and moving average.
Impact on Financial Statements
The choice of inventory method should reflect a company’s economic circumstances in order to create accurate financial statements. In addition to the inventory method chosen, use of a perpetual or periodic inventory system will affect the amount of current assets in the balance sheet and gross profit in the income statement, especially when prices are changing.
Period of Rising Prices
Under FIFO: Ending Inventory is higher, and Total Current Assets are higher; cost of goods sold is lower, and gross profit is higher.
Under LIFO: Ending Inventory is lower, and total current assets are lower; cost of goods sold is higher, and gross profit is lower.
Period of Falling Prices
Under FIFO: Ending Inventory is lower, and total current assets are lower; cost of goods sold is higher, and gross profit is lower.
Under LIFO: Ending Inventory is higher, and total current assets are higher; cost of goods sold is lower, and gross profit is higher.