In either case excessive cash tied up in inventories reduces a companys

In either case excessive cash tied up in inventories

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availability of goods from the company’s suppliers. In either case, excessive cash tied up in inventories reduces a company’s solvency. This ratio is vital for small-business managers who must make very effective use of the limited capital available to them. Just what is an appropriate turnover rate depends on the industry, the inventory itself, and general economic conditions. For example, the Brokaw Division of Wausau Papers (in Brokaw, Wisconsin) often has one to three years' worth of raw material inventory (logs) on hand. Because the road and weather conditions limit the time when wood can be received in Northern Wisconsin, Wausau Papers is forced to have a very slow inventory turnover rate for raw materials at that particular plant. However, finished goods (cut, colored paper) turn over every 28 days. If inventory turnover for the firm is consistently much slower than the average for the industry, then inventory stocks probably are either excessively high or contain a lot of obsolete items. Excessive inventories simply tie up funds that could be used to make needed debt payments or to expand operations. An extremely high turnover rate could be a sign of stock-outs -- not being able to fill a customer’s order because the goods are not on hand. However, on the positive side, if neither stock- outs nor collections are a problem, then a high ratio can be good. K-L Fashions’ balance sheet also shows that, other than plant and equipment, more dollars have been invested in inventory than any other asset category. Given the type of firm, this is not unusual. However, the inventory turnover rate for the company is only 4.5 items per year [$3,573,070 ÷ $797,860], meaning that it takes an average of 81.5 days [365 ÷ 4.5] for the company to sell its inventory once it is purchased. This translates into about 81 days of inventory. Does this indicate too much inventory for the rate at which it is selling? On the surface it might seem excessive, considering that inventory balances should be at a low point after the Christmas sales rush. A look at similar companies, however, reveals that K-L Fashions’ turnover is not much slower than the industry average of 5.1 times (or 72 days). Even with this level of inventory, management stated in its annual report that the company was able to fill only 82 percent of orders from goods on hand. Short-Term Creditors Short-term creditors, including managers who extend credit to trade customers, are interested in the solvency of borrowers or customers. As a result, they tend to focus on the current section of the balance sheet. The same calculations that a manager does on his/her own financials statements can also be done on a debtor’s financial statements. The most widely used financial ratios used to answer questions of short-term solvency are the current ratio and quick ratio .
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