Problem 11 - Accounting

Question

The following data were extracted from the income statement of Mountain Sports Inc.: \begin{tabular}{lrr} & \multicolumn{1}{c}{2006} & \multicolumn{1}{c}{2005} \\ \hline Sales & \(\$ 656,000\) & \(\$ 774,000\) \\ Beginning inventories & 42,000 & 44,000 \\ Cost of goods sold & 328,000 & 430,000 \\ Ending inventories & 40,000 & 42,000 \end{tabular} a. Determine for each year (1) the inventory tumover and (2) the number of days' sales in inventory. Round to nearest dollar and two digits after the decimal place. b. What conclusions can be drawn from these data concerning the inventories?

Step-by-Step Solution

Answer

2006 saw decreased inventory turnover and increased days in inventory compared to 2005, indicating slower inventory movement.

Step 1: Calculate Average Inventory for Each Year

The average inventory for each year is calculated by taking the sum of the beginning and ending inventories, then dividing by 2. For 2006: \( \text{Average Inventory} = \frac{\\(42,000 + \\)40,000}{2} = \\(41,000 \). For 2005: \( \text{Average Inventory} = \frac{\\)44,000 + \\(42,000}{2} = \\)43,000 \).

Step 2: Determine Inventory Turnover for Each Year

Inventory turnover is calculated as the cost of goods sold divided by the average inventory. For 2006: \( \text{Inventory Turnover} = \frac{\\(328,000}{\\)41,000} \approx 8.00 \). For 2005: \( \text{Inventory Turnover} = \frac{\\(430,000}{\\)43,000} \approx 10.00 \).

Step 3: Calculate the Number of Days' Sales in Inventory for Each Year

The number of days' sales in inventory is calculated by dividing 365 days by the inventory turnover ratio. For 2006: \( \text{Days' Sales in Inventory} = \frac{365}{8.00} \approx 45.63 \text{ days} \). For 2005: \( \text{Days' Sales in Inventory} = \frac{365}{10.00} \approx 36.50 \text{ days} \).

Step 4: Analyze Inventory Data

In 2006, the inventory turnover decreased compared to 2005, indicating that inventory was moving slower. The increase in the number of days' sales in inventory from 36.50 days to 45.63 days supports this finding, suggesting decreased efficiency in inventory management.

Key Concepts

Inventory Turnover

Inventory turnover is a crucial metric for businesses as it indicates how often a company sells and replaces its stock over a period. To calculate this, we use the formula:

• \( \text{Inventory Turnover} = \frac{\text{Cost of Goods Sold}}{\text{Average Inventory}} \)

A higher turnover ratio implies that a company is efficient in managing its inventory, selling its products quickly. Conversely, a lower ratio may indicate overstocking, obsolescence, or inefficiencies. For Mountain Sports Inc., the turnover was 8.00 in 2006, down from 10.00 in 2005, indicating a slower movement of inventory in 2006.
This decrease might be concerning for the business as it suggests that the products are not selling as fast, which could impact cash flow and profitability.

Income Statement Analysis

Analyzing the income statement helps in understanding a company's performance over time. Key components such as sales, cost of goods sold, and inventories affect crucial metrics like inventory turnover and profitability.

• Sales indicate the total revenue generated from business activities.
• Cost of goods sold (COGS) represents the direct costs attributable to the production of the goods sold.
• Beginning and ending inventories affect the cost calculation and stock management insights.

In the case of Mountain Sports Inc., a drop in sales from 2005 to 2006, coupled with a decrease in inventory turnover, suggests potential challenges. Such analysis could indicate that either market conditions have changed or operations might need improvement. Evaluating these aspects helps companies make strategic adjustments.

Days' Sales in Inventory

Days' sales in inventory (DSI) measures how many days it takes to sell the average inventory balance. It's an essential metric for understanding inventory liquidity and operational efficiency. The formula for DSI is:

• \( \text{Days' Sales in Inventory} = \frac{365}{\text{Inventory Turnover}} \)

This metric helps businesses understand how long their current inventory stock will last without replenishment. A lower DSI number is generally favorable, indicating a quick turnover of inventory.
For Mountain Sports Inc., the DSI increased from about 36.50 days in 2005 to approximately 45.63 days in 2006. This increment suggests that it took the company longer to sell its inventory in 2006, signaling potential inefficiencies in inventory management or shifts in market demand. Monitoring DSI is crucial for optimizing inventory levels and improving cash flow.