Inventory management ratio analysis of Ford and GM - Essay Example

Inventory management ratio analysis of Ford and GM Inventory turnover ratio indicates the number of times the inventory in a specific company is converted to sales and replaced over a period. The days in a specific period are determined and divided by the inventory turnover formula to give the days it takes to sell the goods in stock. This is also known as the inventory days. There are two methods of calculating the inventory turnover. The first one is by dividing the cost of goods with the average inventory while the second is by dividing the sales with the total cost of inventory. The second is mostly used since both the sales and the total cost of inventory are presented at market values. In markets with seasonal variations in inventories, it is usually advisable to use the first method, which incorporates the average inventory levels. The inventory turnover ratio determines the management’s efficiency in converting the available inventory into sales. A low inventory turnover is a bad sign to a company’s performance since it indicates that the company’s products risk deteriorating. The company’s product will diminish in value due to overstaying in the stores. Due to this phenomenon, companies dealing with perishable goods usually have very high inventory turnover (Bull, 78). The average days to sell inventory is a financial measure that gives the willing investors an idea of the duration it takes for converting the available inventory into revenue. Therefore, a company’s performance ratio determines management efficiency in converting the stock into sales. In most scenarios a low average days to sell ratio is desirable. This ratio varies between industries. The average days to sell ratio is calculated as the total cost of inventory divided by cost of sales and the result got from the computation multiplied by 365 days. An average day to sell ratio forms one part of the cash conversion cycle. It represents the conversion raw material into cash. The day’s sales outstanding and the day’s payable outstanding are the other two stages in the cash conversion cycle. By determining how long a company holds on inventory before selling measures the company’s efficiency ratio. The ratio gives the average time it takes for a company’s cash to be tied up. The inventory turnover ratio of Ford is 15.9 times while that of GM is 10.0 times. The calculation of the inventory turnovers in both the companies has used the average inventory. The average inventory was preferred to total cost of inventory since both the companies have different levels of inventory on different seasons. The inventory turnover ratio imply that Ford converts its inventories 15.9 times in a given a financial period while GM converts its inventories to cash 10 times in a given financial period. Both the companies have high inventory turnover ratios when evaluated individually but it is convenient for the ratio to be compared with industry standards. Ford has a higher inventory turnover than GM. Since both the companies are in the automobile industry, a comparison of the two ratios is appropriate in determining the different firms’ efficiency levels. Ford’s management is more efficient than GM’s management due to its higher inventory turnover rate. Ford’s average days to sell are 23days while GM’s is 36.5 days. This imply that Ford’s inventory stay in the warehouse for 23 days before they are sold while GM’s inventory stay 36.5 days before converted into revenue. Both the companies’ average days to sell ratio indicate that both the entities have good efficiency. Evaluating the average days to sell ratio is of each company separately is not sufficient. Investors need to compare the company’s performance with either past performance or industry performance. Since the two companies are in the same industry, it is highly vital to do a comparison of their average days to sell ratio. The average days to sell ratio of Ford is lower than that of GM implying that Ford’s management is more efficient than that in GM. According to the analyses done above, it is evident that Ford has a higher turnover while GM has a lower one. This difference in inventory turnover raises many questions as the company with the lowest ratio, GM, ironically has higher revenue than the industry. Deeper scrutiny about the issue leads to the investigation cost flow assumption that the individual companies use in their valuation of inventory. An entity can use three methods to value its inventory: the first-in, first-out (FIFO) method; the last in, last out (LIFO) method; and the weighted average costing (WAC) method. According to the FIFO method, the company matches its inventory with the current revenue. This method ensures that the first inventory to enter the warehouse becomes the first one also to come out of the warehouse. This implies that the sales at a given time will be matched with the cost of inventory that is the oldest in the warehouse. According to the LIFO method, the sales do not match with the inventories in the warehouse. The last inventory to enter the warehouse becomes the first one to get out of the warehouse. This implies that the sales are matched with the cost of inventory that entered the warehouse last. This is only efficient in a just in time market. According to the weighted average costing method, the sales are matched with the average cost of all the inventories in the warehouse. In this method, the sales do not match specific inventory but just the average cost of the total inventory. In a normal market such as the one dictating the automobile industry, prices go up as time goes due to the effects of inflation. An increase in prices over time will result in the FIFO method having cheaper inventory, followed by the weighted average costing method then LIFO method as the most expensive. Ford is probably using the FIFO method since it has a higher inventory turnover despite its low revenue. This implies that the costs of its inventory are cheaper. GM is either using LIFO method or the weighted average costing method to value its inventory. This is because it has a low inventory turnover despite its high revenue. This indicates that its inventory have a high cost (Bull, 83). Work Cited Bull, Richard. Financial Ratios. Oxford: CIMA, 2008. Print. Read More