Web Appendix 16A

Web Appendix 16A - 19819_16Aw_p1-5.qxd 1/19/06 10:40 AM...

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Errors in establishing inventory levels quickly lead either to lost sales or to excessive car- rying costs; thus, inventory management is as important as it is difficult. Inventory man- agement techniques are covered in depth in production management courses. Still, since financial managers have a responsibility both for raising the capital needed to carry inventory and for the firm’s overall profitability, we need to cover the financial aspects of inventory management here. Two examples will make clear the types of issues involved in inventory management, and the financial problems poor inventory control can cause. Retail Clothing Store Chicago Discount Clothing (CDC) must order swimsuits for summer sales in January, and it must take delivery by April to be sure of having enough suits to meet the heavy May- June demand. Bathing suits come in many styles, colors, and sizes, and if CDC stocks incorrectly, either in total or in terms of the style-color-size distribution, then the store will have trouble. It will lose potential sales if it stocks too few suits, and it will be forced to lower prices and take losses if it stocks too many or the wrong types. The effects of inventory changes on the balance sheet are important. For simplicity, assume that CDC has a $10,000 base stock of inventory that is financed by common stock. Its balance sheet is as follows: Inventory (base stock) $10,000 Common stock $10,000 Total assets $10,000 Total claims $10,000 Now it anticipates that it will sell $5,000 of swimsuits (at cost) this summer. Dollar sales will actually be greater than $5,000, since CDC makes about $200 in profits for every $1,000 of inventory sold. CDC finances its seasonal inventory with bank loans, so its presummer balance sheet would look like this: Inventory (seasonal) $ 5,000 N/P to bank $ 5,000 Inventory (base stock) $10,000 Common stock $10,000 Total assets $15,000 Total claims $15,000 If everything works out as planned, sales will be made, inventory will be converted to cash, the bank loan will be retired, and the company will earn a profit. Cash $ 1,000 N/P to bank $ 0 Inventory (seasonal) 0 Common stock 10,000 Inventory (base stock) 10,000 Retained earnings 1,000 Total assets $11,000 Total claims $11,000 The company is now in a highly liquid position and is ready to begin a new season. But suppose the season had not gone well, and CDC had only sold $1,000 of its inventory. Cash $ 200 N/P to bank $ 4,000 Inventory (seasonal) 4,000 Common stock 10,000 Inventory (base stock) 10,000 Retained earnings 200 Total assets $14,200 Total claims $14,200 Now suppose the bank insists on repayment of the $4,000 outstanding on the loan, and it wants cash, not swimsuits. But if the swimsuits did not sell well in the summer, how will out-of-style suits sell in the fall? Assume that CDC is forced to mark the suits down to half their cost (not half the selling price) in order to sell them to raise cash to repay the bank loan. WEB APPENDIX
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Web Appendix 16A - 19819_16Aw_p1-5.qxd 1/19/06 10:40 AM...

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