What is Inventory? Inventory refers to the stock of goods or raw materials a business uses to produce the final goods sold to the customers. What is the Inventory Turnover Ratio? Inventory Turnover Ratio is the financial ratio that shows how efficiently a business sells and replenishes its inventoryRead more
What is Inventory?
Inventory refers to the stock of goods or raw materials a business uses to produce the final goods sold to the customers.
What is the Inventory Turnover Ratio?
Inventory Turnover Ratio is the financial ratio that shows how efficiently a business sells and replenishes its inventory. It shows how well a business manages its inventory.
Inventory Turnover ratio is calculated as follows:
Inventory Turnover Ratio = Cost of goods sold / Average Inventory
where Average Inventory = (Inventory at the beginning of the year + Inventory at the end of the year) / 2
If inventory turnover is high, it means products are selling quickly. But if it’s too high, the company might not have enough stock, leading to fewer sales.
If turnover is low, there are slow sales or too much stock. That can lead to higher storage costs and obsolete products. It is important to find the right balance between the two.
Why is the Cost of Goods Sold taken as a numerator instead of revenue while calculating the Inventory Turnover Ratio?
The cost of goods sold is the sum of all the direct costs involved in the production of goods. On the other hand, Revenue is the total amount of money earned through the sale of goods and services.
The cost of goods sold (COGS) includes materials, labor, and overhead costs. Inventory consists of these costs and hence, it is better to take (COGS) as the numerator.
Revenue, however, considers things like markups, discounts, and other adjustments that don’t directly relate to the actual cost of inventory.
Let us understand it better with the help of an example:
Suppose the opening inventory is 20,000 and the closing inventory is 10,000. Average inventory can be calculated as (20,000 + 10,000)/2 = 15,000.
If the cost of goods sold is 45,000 the Inventory turnover ratio comes out to be 45,000/15,000 = 3.
On the other hand, if the revenue of 60,000 is taken as the numerator, the Inventory turnover ratio comes out to be 60,000/15,000 = 4
A high inventory turnover ratio shows that the inventory is moving faster than it is which is misleading for the stakeholders.
Hence, the Cost of goods sold is taken as the numerator for the calculation of the Inventory turnover ratio.
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Everyone must have heard about the term “cooking the books”. This term is generally associated with Creative accounting. In simple words, Creative accounting is a method of accounting in which the management tries to show a better picture of the business than the reality. Let us now understand thisRead more
Everyone must have heard about the term “cooking the books”. This term is generally associated with Creative accounting. In simple words, Creative accounting is a method of accounting in which the management tries to show a better picture of the business than the reality. Let us now understand this concept in detail.
What is Creative accounting?
Creative accounting is a method of accounting in which the management manipulates the books of accounts by finding loopholes to showcase a better image of the business.
It is a practice of using accounting loopholes to make a company’s financial position look better than it really is. It is not exactly illegal but it is more of a gray area.
For example, a business may delay reporting expenses to increase the profits to present a better short-term position.
The goal of creative accounting is to impress the shareholders, investors, get loans or boost stock prices.
However, this can also be very risky and have serious consequences. It can reduce the trust of the investors and customers. In some cases, like Enron and WorldCom the world has seen how creative accounting lead to legal consequences.
Common Techniques of Creative Accounting
Some of the common techniques used by the business to manipulate the financial position are as follows:
Ethical implications of Creative Accounting
There are several ethical implications with respect to creative accounting. Some of these are discussed below:
Conclusion
The key takeaways from the above discussion are as follows: