Inventory Management Business Entities, Whether

Inventory Management

Business Entities, whether a large scale or down to a small scale business, have to maintain sufficient amount of resources to maintain current and on-going operations. Cash is the main resource of a Business. In view of finance, cash is the most liquid form of asset characterized as having a fixed value and can easily be converted. A simple and classic illustration of a business' cash conversion: Merchandising or Manufacturing concerned businesses uses cash to acquire, make and maintain inventories for sale. A service concerned business on the other hand maintains supplies. Companies with a practice of extending credit to customers from sale or from services rendered generate receivable accounts. These accounts return in the form of cash upon collection. In view of business, cash is considered as the lifeblood of business operations, without which no transactions take place as cash is the primary medium of exchange. Absence or lack of cash likely produces such effect and places the entity into a borrowing state, thus incurring outstanding obligations to creditors. In contrast, an excess of cash put on hold would result to such cash being idle, useless and stripped off of its earning potential. These views on cash form part of working capital and in relation to its sufficiency and management.

Working capital is determined to be the excess of current assets over current liabilities. It is an essential part of business because it is used in the administration of operations. In absence of any current if not currently maturing obligations, current assets composing the aggregate of cash, marketable equity securities, trade and other receivables, inventories and prepaid expenses constitute working capital thus it should be managed efficiently and effectively to optimize its use. Implementing a working capital management system is an excellent way to ensure the continuity of a company's operations and improve its earning capacity. The two main aspects of working capital management are ratio analysis and management of individual components of working capital.

In keeping perspective with working capital management, it is best to describe how the cycle works. The cycle starts with the inflow of cash into the business. The conversion of cash is then observed while the business utilizes it in its operations.

Such conversion is the same as earlier mentioned with a clear visual as provided below:

The cycle as the illustration simply indicates that the cash infused in the business are used in view or for the purpose of earning an increased amount of cash as output to be applied in payment of operating expenses as well as to profit.

In the usual course of businesses, in order to generate income, you must have an initial cash outlay. It goes with the saying "To make money, spend some money." However, the bigger the investment, the bigger the expected risk on your money. The more thought and concern should be placed in management to effectively utilize and safeguard assets. In the previous illustration, let us place ourselves in either a merchandising or a manufacturing concerned business. In this particular scenario, 1) a cash outlay happens in payment for goods or materials and supplies in order to (2) produce final products to sell, forming part of inventory.

Once the product is ready, the products are sold to the customers. Please take note that products can be sold while customer defers payment or products can be sold on a cash basis. Deferred payment means the (3 and 4) customer can acquire products while payment will be made on a later date. This is when Accounts Receivables is created. Accounts Receivables can be defined as claim against a debtor, in this instance, the customer, for the uncollected amount, generally from a completed transaction of sales or services rendered. Here, there is a time lag before the Company receives payment and completes the cycle. Another option, which is the best way of making business, is (5) selling products on a cash basis. In both cases, (6) there is an inflow of cash from the transaction, one takes time while the other is immediate.

From cash outflow of paying suppliers (payable) to production (inventory) and selling on account (receivables) to finally receiving cash (cash inflow) is what we call the working capital cycle. It is the business's life blood and every manager's primary task is to help keep it flowing and to use the cash flow to generate profits.

A quantitative method is made available to analyze and determine whether the company can satisfy their expectations, for instance whether it can pay its employees and suppliers, repay loans, pay dividends on its stocks and expand into new areas. This method is called Financial Statement Analysis. Important considerations in this method are ratios, trends and comparison of these against some norms. Ratios can be in three different forms: Some ratios are comparison of an income statement element with other income statement elements, some are of balance sheet elements with other balance sheet elements and others are comparison of income statement elements like sales or cost of goods sold, with balance sheet elements such as accounts receivables or total assets. Trends are of interest as clues to the future. Through this analysis, we can see and observe, from a third party or management's point-of-view on how we can improve, manage and improve our resources.

Many people and organizations outside a company, such as suppliers, investors, banks and other institutions are interested in its activities. Short-term creditors, such as suppliers and banks considering loan of relatively short duration are concerned primarily with a company's short-term prospects. They want to know whether a company will be able to pay its obligations in the near future. Banks, insurance companies, pension funds, and other investors consider relatively long-term commitments. In this instance, we would be focusing on the short-term particularly in the interest of working capital.

To further illustrate, below is a sample comparative financial statements of ABC Company. We will use this illustration in discussing ABC Company's prospect into the area of liquidity.

ABC COMPANY

BALANCE SHEETS as of 2006 & 2006

ABC Company, Balance Sheets as of December 31

Current Assets:

Cash

Accounts Receivables, net

Inventory

Total Current Assets

Property, Plant and Equipment - cost

Accumulated depreciation

340,000.00)

250,000.00)

Net of Property, Plant and Equipment

Other Assets

Total Assets

Current Liabilities

Accounts Payable

Accrued Expenses

Total Current Liabilities

Long-term Debt

Total Liabilities

Common stock, 22,000 shares

Paid-in Capital

Retained Earnings

Total Stockholders' Equity

Total Equity

ABC COMPANY

INCOME STAMENTS for the YEARS ENDED 2006 & 2005

ABC Company, Income Statements for the Year Ended December 31

Sales

Cost of Goods Sold

Gross Profit

Operating Expenses

Income before Interest and Taxes

Interest Expense

Income before taxes

Income Taxes at 40% Rate

Net Income

Liquidity is a company's ability to meet obligations due in the near future. The more liquid ABC Company is, the more likely it will be able to pay its employees, suppliers and holders of its short-term notes payable.

In analyzing its liquidity, we first identify how much is working capital. As previously defined, working capital is the difference between current assets and current liabilities. ABC's working capital at the end of 2006 and 2005 are $250,000 and $240,000, respectively. It shows working capital increased from 2005 to 2006 and both years have positive figures. We can initially see here that the Company adequately managed its operations. These give us an idea a liquid company however these do not indicate that ABC has adequate liquidity or became more liquid because working capital is just a rough measure of changes in liquidity and supplements other analysis with several other calculations.

Other calculations relate to other ratios and computations that measures relative liquidity that considers differences in absolute sizes.

We now take into account current ratio which is used to compare company's liquidity from year to year. Current ratio is computed by dividing Current Assets with Current Liabilities. ABC has current ratio of 3.50 in 2006 and 3.67 in 2005. In this instance, we see that the Company "seemed to be more liquid" than in prior year. Again, this is not in absolute terms because computation based on total, such as total current assets or liabilities, might mask information about individual components on these area.

We can also asses ABC's liquidity by computing its Quick Ratio or Acid-Test Ratio. Quick Ratio is computed by dividing the sum of cash, marketable securities and accounts receivables with current liabilities. It is similar to current ratio but here it takes into consideration assets that are cash or "near cash" hence quick assets. This ratio gives a stricter indication of short-term debt paying ability than does the current ratio. Since ABC does have not marketable securities, we only use cash, accounts receivables and current liabilities in the computation. Its quick ratio is 1.70 and 1.33 for 2006 and 2005, respectively.

ABC seemed to be less liquid in this instance because its quick ratio increased. We can say that the company was able to meet current liabilities in 2005 as compared to 2006.

In analyzing a Company, we can also compute its gross profit ratio and return on sales. Gross profit ratio is computed by dividing gross profit with sales and return on sales is computed by dividing net income by sales. Respectively, 2006 and 2005 ratios of ABC Company are as follows: 39% and 38% in gross profit; and 16% and 15% in return on sales.

Other quantitative measurement of its liquidity is going into detailed of each current assets account using working capital activity ratios. This provides information about the time within which ABC Company should realize cash from its receivables and inventories. and, although we cannot tell the time within which the Company must pay its various current liabilities by examining the financial statements, we can use ratio to offer us some insight into the company's bill paying practices or how long customers pay their account.

Working capital ratios are accounts receivables turnover, days' sale in accounts receivables, inventory turnover and days' sale in inventory. The following paragraphs will be discussing these particular ratios.

Accounts receivables (AR) turnover measures how rapidly a company collects its receivables. AR turnover is computed by dividing sales with average accounts receivables. Average receivables is defined as the beginning accounts receivables (in this instance, AR of 2005) plus ending balance (AR of 2006) divided by 2. Because we do not have the beginning balance for 2005, we can only calculate the turnover of average receivables for 2006. We can calculate turnover of 2005 using its end of year value. In this particular ratio, turnover of ABC Company increased by 15% from 33.75 in 2005 to 40.00 in 2006. This is good because ABC is able to collect 6.25 times better than in previous year.

With relation to this, we can also calculate the number of days' sales in AR. Computation of this ratio is ending accounts receivables divided by average daily sales. Average daily sales is Total Sales for the year divided by 365 days. This indicates the average age of ending accounts receivables. On average, accounts receivables of ABC Company are 9 days old in yearend of 2006 and 11 days old in 2005, respectively. Decreased in average days' sales in accounts receivables can be a positive note. It means customers pay their accounts in a shorter length as compared last year.

Next we can compute on the inventory turnover. It is calculated by dividing Cost of Goods Sold with Average Inventory. Average inventory is computed by dividing the sum of beginning and ending of yearend inventory balance by 2. This turnover indicates the efficiency with which a company uses its inventory. Again, we can only compute the average balance for 2006 because there is no available beginning balance for 2005. Thus, ABC's inventory turnovers are 4.70 in year 2006 and 3.99 in year 2005. Increased in inventory turnover can be a good point. Higher inventory turnover is critical for many businesses to generate high sales and earn satisfactory profit.

Additional part of Working Capital Ratio analysis is computation of Days' sales in inventory. Computation is done by dividing ending inventory by average daily cost of goods sold. Average cost of goods sold is simply cost of goods sold for the year divided by 365 days. For ABC Company, this is 71.69 for 2006 and 91.58 for 2005.

These ratio analyses can be a helpful tool in deciding whether the Company you are interested in getting involved with is a going concern or can able to sustain its growth and provide employees, suppliers, debtors and investors with the necessity and other requirements.

Based on the financial analysis made with regards to ABC Company, can we say that it is best to be part of the Company whether as an employee, customer, supplier or investor?

Working Capital

Current Ratio

Quick Ratio

Gross Profit Ratio

Return on Sales

Accounts Receivables Turnover

Days' Sale in Accounts Receivables

Inventory Turnover

Days' sales in Inventory

Based on the summary of financial analyses presented above, we can say that ABC is a profitable and growing Company. Although there is a decreased of 0.17 or 4% in Current ratio, there is a positive and increase working capital of $10,000 and increase if 0.37 or 21%, in Quick Ratio. It means that on current liability of $1, the company has a current asset of $3.50 in 2006 and 3.67 in 2005 whereas $1 of current liability, it has "near cash" availability of $1.70 in 2006 and $1.33 in 2005. In both instances, this is a positive note signifying that it has the ability to pay its obligation in the near future.

Gross profit ratio and return on sales both increased by 1%. This is a good note because despite increase of cost of goods sold and operating expenses, ABC is still able to control expenses and increase sales. It can also be attributed with management of long-term debt, thus maintaining finance cost in a controllable manner.

It is also a good point of an increased AR Turnover by 15% and decrease of days' sale in AR by 27%. It can be interpreted that customers has the capacity and is able to pay their account within credit term or less. It also connotes that sales tie up with AR is lesser than previous year, thus is converted to cash in an earlier phase.