In either case excessive cash tied up in inventories

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 .