Monitoring the inventory turnover ratio over time can

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Intermediate Financial Management
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Chapter 4 / Exercise 044
Intermediate Financial Management
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the higher the ratio the more profitable a company will be. Monitoring the inventory turnover ratio over time can highlight potential problems. A declining ratio generally is unfavorable and could be caused by the presence of obsolete or slow-moving products, or poor marketing and sales efforts.Recall that the ratio is computed as follows:If the analysis is prepared for the fiscal year reporting period, we can divide the inventory turnover ratio into 365 days to calculate the average days in inventory,which indicates the average number of days it normally takes the company to sell its inventory.For GAPT, the inventory turnover ratio for the 2009 fiscal year, using the 100% FIFO amounts, is 13.33 ($6,605 ÷ [($484 + 507) ÷ 2]) and the average days in inventory is 27 days (365 ÷ 13.33). This compares to an industry average of 23 days. GAPT's products command a higher markup (higher gross profit ratio) but take longer to sell (higher average days in inventory) than the industry average.Page 12 of 14Inventory Cost Flow Assumptions1/22/2011...
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Intermediate Financial Management
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Chapter 4 / Exercise 044
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2011 McGraw-Hill Higher Education Any use is subject to the Terms of Use and Privacy Notice. McGraw-Hill Higher Education is one of the many fine businesses of The McGraw-Hill Companies. Inventory increases that outrun increases in cost of goods sold might indicate difficulties in generating sales. These inventory buildups may also indicate that a company has obsolete or slow-moving inventory. This proposition was tested in an important academic research study. Professors Lev and Thiagarajan empirically demonstrated the importance of a set of 12 fundamental variables in valuing companies' common stock. The set of variables included inventory (change in inventory minus change in sales). The inventory variable was found to be a significant indicator of returns on investments in common stock, particularly during high and medium inflation years.16EARNINGS QUALITY.Changes in the ratios we discussed above often provide information about the quality of a company's current period earnings. For example, a slowing turnover ratio combined with higher than normal inventory levels may indicate the potential for decreased production, obsolete inventory, or a need to decrease prices to sell inventory (which will then decrease gross profit ratios and net income).The choice of which inventory method to use also affects earnings quality, particularly in times of rapidly changing prices. Earlier in this chapter we discussed the effect of a LIFO liquidation on company profits. A LIFO liquidation profit (or loss) reduces the quality of current period earnings. Fortunately for analysts, companies must disclose these profits or losses, if material. In addition, LIFO cost of goods sold determined using a periodic inventory system is more susceptible to manipulation than is FIFO. Year-end purchases can have a dramatic effect on LIFO cost of goods sold in rapid cost-change environments. Recall again our discussion in Chapter 4 concerning earnings quality. Many believe that

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