Monitoring Inventory Management We can monitor inventory by looking at financial ratios in much the

Monitoring Inventory Management We can monitor inventory by looking at financial ratios in much the

same way we can monitor receivables. The number of days of inventory is the ratio of the dollar value of inventory at a point in time to the cost of goods sold per day:

Inventory Number of days of inventory = ------------------------------------------------------------------------------------ (20-7)

Average day’s cost of goods sold This ratio is an estimate of the number of days’ worth of sales you have

on hand. Combined with an estimate of the demand for your goods, this ratio helps you in planning your production and purchasing of goods. For example, automobile manufacturers keep a close watch on the num- ber of days of autos on car lots. If there are more than is typical, they tend to offer rebates and financing incentives. If there are fewer than is typical, they may step up production.

Another way to monitor inventory is the inventory turnover ratio— the ratio of what you sell over a period (the cost of goods sold) to what you have on hand at the end of that period (inventory):

Cost of goods sold Inventory turnover = ------------------------------------------------

(20-8)

Inventory

The inventory turnover ratio tells you, on average, how many times inventory flows through the firm—from raw materials to goods sold— during the period. If the typical inventory turnover for a firm is, say, five times, that means that the firm completes the cycle of investing in inven- tory and selling it five times in the year. If the turnover is above the typ- ical, this may suggest a possible stock-out. If the turnover is less than usual, this may suggest either production is slower (resulting in rela-

MANAGING WORKING CAPITAL

tively more work-in-process) or that sales are sluggish and perhaps need

a boost from providing sales incentives or discounting prices. You must be careful, however, in interpreting these ratios. Because the production and sale of goods may be seasonal—and not always in sync—the value you put into your calculations may not represent what is actually going on. Most firms select the lowest point in their seasonal pattern of activity as their fiscal year-end. For example, Toys ’R Us ends its fiscal year on January 31 since its peak business period is the Christ- mas season. For the 2002 fiscal year, the Toys ’R Us inventory was:

Quarter End Inventory (in Millions)

The cost of goods sold for these four quarters was $7,661 million. If we calculate the inventory turnover using August 3, 2002 inventory, the Toys ’R Us inventory turnover was 3.1 times. If, on the other hand, we use average inventory (averaging the four quarter-end inventories), the inven- tory turnover was 2.98 times. While both are correct values for inventory turnover, 2.98 times is probably more representative of the firm’s manage- ment of inventory throughout the year.

Also, interpretation of an inventory turnover ratio is not straightfor- ward. Is a higher turnover good or bad? It could be either. A high turn- over may mean that the firm is using its investment in inventory efficiently. But it might mean that the firm is risking a shortage of inven- tory. Not keeping enough on hand (relative to what is sold) incurs a chance of lost sales and customer goodwill. If Toys ’R Us runs out of stock on the “hottest” toys in the Christmas season, you can be sure that customers will shop elsewhere. Using inventory turnover ratios along with measures of profitability can give you a better idea of whether you are getting an adequate return on your investment in inventory.