Analysis of Inventories

The income statement contains information about profitability and the balance sheet contains useful information about inventory levels.

Profitability – The income statement contains information about cost of goods sold and gross profit. Gross profit is often expressed as a percentage of sales:

Gross profit % = Gross profit / Sales

A higher gross profit percentage helps cover other expenses and contributes to net income.

OB’s gross profit percentage showed a reasonable increase between 1996 and 1997. Several factors may have caused this. First, OB’s inventory costs may have fallen. Second, competitive forces may have enabled OB to increase its selling prices. Finally, keep in mind that OB’s different products probably have varying gross profit percentages. A change in the mix of products sold can affect the gross profit percentage. OB’s gross profit percentage compares favorably to other apparel manufacturers.

Industries differ with respect to gross profit percentage. For example, the pharmaceutical industry’s average gross profit percentage exceeds 50%. Drug companies incur substantial costs when researching and developing their products. Accordingly, they must sell their goods at relatively high markups so that they can cover these costs and remain profitable.

Inventory Levels – The balance sheet contains information about the cost of inventories remaining on hand at year-end. This provides insights into whether the level of inventory is adequate to meet customer demands. Inadequate levels may result in lost sales and reduced profitability, while excessive levels increase carrying costs, which also has a negative impact on profitability. Carrying costs include storage, handling, insurance, and the opportunity cost of the funds invested in inventory. An opportunity cost exists because cash invested in inventory that remains on hand for several months cannot be invested in more profitable alternative opportunities.

The number of days’ sales in ending inventory (NDS) is frequently used to measure inventory levels. It is computed in two steps. First, divide cost of goods sold by 365. This indicates the cost of inventory sold in one day.

CGS per day = CGS / 365

Next divide ending inventory by CGS per day to obtain NDS.

NDS = Ending inventory / CGS per day


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