Financial Statement Analysis Page 15
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Chapter 15
enough inventory to handle sales for over 79 days (365/4.6 times). This is very low
for its industry, which has an average turnover of 27.7 times per year. This ratio has
identified an area that Greg’s Tunes needs to improve.
Days in Inventory
Another key measure is the number of days in inventory ratio. This measures the
average number of days inventory is held by the company. Greg’s Tunes’ days in
inventory for 2014 is as follows:
Greg’s Tunes’
Industry
Formula
Days in Inventory
Average
365 days
365 days
Days in inventory
=
= 79 days
13 days
Inventory turnover ratio
4.6
Days in inventory varies widely, depending on the business. Greg’s Tunes’ days in
inventory is 79 days—too high for its industry, which has a days in inventory ratio
of only 13 days. This ratio has identified an area that Greg’s Tunes needs to improve.
Greg’s Tunes should focus on reducing average inventory held. By decreasing aver-
age inventory, the company can increase inventory turnover and lower the average
days in inventory. Greg’s will also be able to reduce its inventory storage and insur-
ance costs, as well as reduce the risk of holding obsolete inventory.
Gross Profit Percentage
Gross profit (gross margin) is net sales minus the cost of goods sold. Merchandisers
strive to increase the gross profit percentage (also called the gross margin
percentage). This measures the profitability of each net sales dollar.
Greg’s Tunes’ gross profit percentage for 2014 is as follows:
Greg’s Tunes’
Industry
Formula
Gross Profit Percentage
Average
Gross profit
$345,000
Gross profit percentage =
= 0.402 or 40.2%
43%
Net sales
$858,000
Gross profit percentage varies widely, depending on the business. Greg’s Tunes’
gross profit percentage is 40.2%, which is slightly lower than the industry, which
has a gross profit percentage of 43%. This ratio has identified an area that Greg’s
Tunes needs to improve. To increase gross profit percentage, Greg’s Tunes needs to
decrease the cost of the merchandise and/or increase revenue (selling price).
Additionally, addressing Greg’s inventory turnover issues will probably help Greg’s
to increase its gross profit percentage.
Accounts Receivable Turnover
The accounts receivable turnover ratio measures the ability to collect cash from
credit customers. The higher the ratio, the faster the cash collections. But a receiv-
able turnover that is too high may indicate that credit is too tight, causing the loss of
sales to good customers.
To compute accounts receivable turnover, we divide net credit sales (assuming all
Greg’s sales from Exhibit 15-8 are on account) by average net accounts receivable.
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