270 SECTION 1 The Role of Accounting as an Information System signal a future increase in bad debts. Ratio analysis does not explain what is wrong. It does provide information that highlights areas for further investigation. INVENTORY TURNOVER. An important activity measure for a merchandising company (a retail, wholesale, or manufacturing company) is the inventory turnover ratio . The ratio shows the number of times the average inventory balance is sold during a reporting period. It indicates how quickly inventory is sold. The more frequently a business is able to sell, or turn over, its inventory, the lower its investment in inventory must be for a given level of sales. The ratio is computed by dividing the period’s cost of goods sold by the average inventory balance. The denominator, average inventory, is determined by adding beginning and ending inventory and dividing by two. 31 A relatively high ratio, say compared to a competitor, usually is desirable. A high ratio indicates comparative strength, perhaps caused by a company’s superior sales force or maybe a successful advertising campaign. However, it might also be caused by a relatively low inventory level, which could mean either very efficient inventory management or stockouts and lost sales in the future. On the other hand, a relatively low ratio, or a decrease in the ratio over time, usually is perceived to be unfavorable. Too much capital may be tied up in inventory. A relatively low ratio may result from overstocking, the presence of obsolete items, or poor marketing and sales efforts. Similar to the receivables turnover, we can divide the inventory turnover ratio into 365 days to compute the average days in inventory . This measure indicates the number of days it normally takes to sell inventory. Average days in inventory 5 _ _____ ___3_6_ 5_ ________Inventory turnover ratio Profitability Ratios A fundamental element of an analyst’s task is to develop an understanding of a firm’s profitability. Profitability ratios attempt to measure a company’s ability to earn an adequate return relative to sales or resources devoted to operations. Resources devoted to operations can be defined as total assets or only those assets provided by owners, depending on the evaluation objective. Three common profitability measures are (1) the profit margin on sales, (2) the return on assets, and (3) the return on shareholders’ equity. These ratios are calculated as follows: Profit margin on sales 5 _ N_e_t_ i_n_c_o_m_ e_ Net sales Return on assets 5 _ ___N__e_t _in_ c_o_m__e_ ___Average total assets Return on shareholder’s equity 5 _ _______N_ e_t_ i_n_c_o_m_e_ _______Average shareholders’ equity Notice that for all of the profitability ratios, our numerator is net income. Recall our discussion in Chapter 4 on earnings quality. The relevance of any historical-based financial statement hinges on its predictive value. To enhance predictive value, analysts often adjust net income in these ratios to separate a company’s transitory earnings effects from its permanent earnings. Analysts begin their assessment of permanent earnings with income from continuing operations. Then, adjustments are made for any unusual, one-time gains or losses included in income from continuing operations. It is this adjusted number that they use as the numerator in these ratios. PROFIT MARGIN ON SALES. The profit margin on sales is simply net income divided by net sales. The ratio measures an important dimension of a company’s profitability. It indicates the portion of each dollar of revenue that is available after all expenses have been covered. It offers a measure of the company’s ability to withstand either higher expenses or lower revenues. The inventory turnover ratio measures a company’s efficiency in managing its investment in inventory. 31 Notice the consistency in the measure used for the numerator and denominator of the two turnover ratios. For the receivables turnover ratio, both numerator and denominator are based on sales dollars, whereas they are both based on cost for the inventory turnover ratio. Profitability ratios assist in evaluating various aspects of a company’s profit-making activities. When calculating profitability ratios, analysts often adjust net income for any transitory income effects. The profit margin on sales measures the amount of net income achieved per sales dollar.
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