Inventory Valuation Methods - Wesfarmers and Woolworths - Case Study Example

ACCOUNTING GROUP ASSIGNMENT: WESFARMERS & WOOLWORTH CASE by Student’s Name Code + Course Name Professor’s Name University Cite, State Date 1. Inventory Valuation Methods For Wesfarmers, inventories are currently being valued at the lower of cost as well as their immediate net realizable values. The costs attributed to each stage of every product in transporting them into their current location and condition are distinguished as follows; First, raw materials used in producing finished stock are bought on te weighted average basis. Second, both finished and work-in-progress goods are valued in accordance with the cost of direct materials as well as labor and also, a significant proportion of manufacturing overheads. Third, commodities that are sold on retail and wholesale basis are valued on a weighted average basis that is focused on purchasing costs (Ashton, 2011). Notwithstanding, the net realizable value of the commodities is arrived at by estimation of the selling price during business activities minus the costs of completion and costs of sales. For Woolworth, the firm also adopts the valuation of inventories as their respective lower costs or in net realizable values. However, the firm does not deploy the weighted average basis on its valuation model. Probable Change of Inventories Valuation Method These firms might make significant strides in both production and profitability by adopting or rather altering their current valuation method to LIFO-Last-In-First-Out methodology. This method presents the costs of goods sold on their immediate cost of material purchased in the course of period end. This, in turn, results to a cost that is closely related to the current costs of the products (Ryan, 2004). In retrospective, under this approach, inventories are valued and presented in regards to the cost of materials that was purchased earlier within the year. These companies should adopt this approach since it allows for immense tax benefits in the course of high inflations. Notwithstanding, numerous research have indicated that firms that experience rising prices for their immediate raw materials and subsequent labor deployed, increases in variable inventory developments, larger-sized firms as well as those that experience tax losses carry forwards will likely benefit from the adoption of LIFO approach (Ryan, 2004). However, it should be noted that whenever firms adopt this methodology, there is a likelihood of them experiencing a drop in the figures related to net income but a subsequent increase in the level of cash flows. This is attributed to the intense savings made from tax benefits. Inventory Turnover Ratio Analysis Wesfarmers; Inventory turnover = sales/inventories of finished goods 2011= 52,891/4,987=10.6 2012=55,897/5,006=11.2 2013=57,467/5,047=11.4 Woolworth; 2011=52,609.1/3,736.5= 14.1 2012=55,129.8/3,698.3=14.9 2013=58,516.4/4,205.4=14.0 The inventory turnover ratio for Wesfarmers rises significantly from 10.6 in 2011 to 11.2 and 11.4 in 2012 and 2013 respectively. On the other hand, for Woolworth, the ratio is relatively positioned above the 14.0 value for all the three years. From this ratio positions, it can be ascertained that Woolworth has devised policies and inventory valuation methods that facilitate easier translation of inventories to sales as opposed to its counterpart Wesfarmers. This means that both of these companies do not hold excessive stock at any moment in time. However, Woolworth is doing much better. 2. Provisions for Bad and Doubtful Debts For Wesfarmers, provisions for doubtful and bad debts are computed using distinctive discount rates that range between 2% and 4%. In order to self-insure against such risks, the provisions are determined and recognized using claims that have already been reported in regards to approximate of claims incurred but not yet reported in the end of the reporting period. Discounting basis, which can be related to the allowance method, is focused on distinctive assumptions that might involve future inflations, investment returns and other related administrations expenses incurred (Ryan, 2006). For Woolworths, provisions are recognized whenever it is ascertained that consolidated firm is experiencing an impending legal or constructive commitment that will lead to probable outflow of economic benefits needed in settling the obligation as a whole. Probable Change of Reporting Provisions f or Doubtful and Bad Debts For both of these firms, the write-off method should be adopted for that matter. This method will affect the income of these companies given that it allows a direct writing-off of receivables. However, this method has one weakness that rests with the fact that it violates the matching principles, which is highly advocated by the GAAP. Accounts Receivables turnover Ratio Accounts receivable turnover ratio= annual credit sales/accounts receivables For Wesfarmers; 2011= 52,891/1,122.2= 47.12% 2012=55,897/2,384= 23.45% 2013=57,467/2,341=25.45% For Woolworth; 2011=52,609.1/1,122.2=46.88% 2012=55,129.8/869.9=63.37% 2013=58,516.4/968.6=60.42% Analysis From the ratios, it can be seen that while Woolworth tries to maintain a higher percentage throughout the three-year period, Wesfarmers’ ratio reduces significantly below the industry average. This is an indication that unlike Woolworth, Wesfarmers takes a longer period of time before it can collect credit sales due to ineffective credit policies. With the increased timeframe to collect accounts receivable means that the firm is much more prone to enormous amounts of doubtful and bad debts (Penman, 2004). Thus, it should adopt a write-off methodology in order to disclose a fairly represented income statement within its financial statements. 5. Capitalizing Versus Expensing Assets Both of these firms can either adopt a capitalization model or expensing models in the course of reporting their respective assets. However, each of these methods has a distinctive effect on the financial items of the companies as expounded below; First, capitalizing assets and other costs and thereafter depreciating them, will postulate a smoother trend on reported incomes. On the retrospective aspect, expensing them will lead to a higher variable on the disclosed income. In regards to profitability, a company that capitalizes assets will depict higher profits in its early years of operations as opposed to when it could have expensed them. On the other hand, a firm that expenses its assets will postulate a higher profitability than if it could have capitalized them (Penman, 2004). In regards to the effect on financial ratios, a firm that capitalizes its assets will postulate a higher profitability ratios in the early years of operations while lower ratios at the later stages of operations. Such activity ratios as the total asset and fixed asset turnover will postulate a lower value under the capitalization approach due to the higher level of fixed assets that have been disclosed. Subsequently, both the return on assets and return on equities will be higher, under capitalization approach, in the earlier years of operations in comparison to the later years. The ratios are calculated as below; Total assets turnover ratio= sales/total assets For Wesfarmers; 2011= 52,891/40,814=1.30 2012=55,897/42,312=1.32 2013=57,467/43,155=1.33 For Woolworth; 2011=52,609.1/20,828.4=2.53 2012=55,129.8/21,581.1=2.55 2013=58,516.4/22,250.2=2.63 Analysis The total turnover ratio for the two companies increases in the three year period. For instance, for Wesfarmers, the ratio increases from 1.30 to 1.32 between 2011 and 2012 and later, it increases to 1.33 in the year ending 2013. On the other hand, Woolworth’s ratio also increases from 2.53 to 2.55 in the years between 2011 and 2012 and later increases to 2.63 in 2013. This indicates that unlike Wesfarmers, Woolworth depicts a higher capacity to post enormous amount of business volume for each plant and equipment held for that matter. Return on Assets (ROA) = Net Income/Total Assets For Wesfarmers; 2011=1,922 /40,814=0.05 2012=2,126/42,312=0.05 2013=2,261/43,155=0.05 For Woolworth; 2011=2,123.6/20,828.4=0.1 2012=2,183.4/21,581.1=0.1 2013=2,254.9/22,250.2=0.1 The return on assets ratio for the two companies remains constant in the three-year period. This ratio stands at 0.05 for Wesfarmers and 0.1 for Woolworth. This means that Woolworth indicates a significant after-taxed level of profits for each dollar invested to secure assets (Ashton, 2011). Return on Equity (ROE) = net income/total stockholder’s equity For Wesfarmers; 2011=1,922 /25,329=0.08 2012=2,126/25,627=0.08 2013=2,261/26,022=0.09 For Woolworth; 2011=2,123.6/7,845.8=0.27 2012=2,183.4/8,446.3=0.26 2013=2,254.9/9,300.5=0.24 The ROE for Woolworth increases though insignificantly in the three-year period. For instance, for Wesfarmers, the ratio increases from 0.8 in the years 2011 and 2012 to 0.9 in the year ending 2013. However, for Woolworth, the ratio decreases insignificantly from 0.27 to 0.26 between the years 2012 and 2012 and further reduces to 0.24. Although there is a reduction, the ratio remains above the industry indicating a higher after-taxed level of profits for each amount of dollar invested as stockholder’s equity. 6. off-balance sheet financing This is a form of financing that allows companies to eliminate the presentation of large capital expenditures from their respective financial balance sheets through a myriad of techniques. Companies will usually utilize off-balance sheet financing in order to keep both their debt-to-equity and leverage ratios at a lower level (Ryan, 2006). Companies use this methodology in order to avoid agreements previously made regarding inclusion of negative debts. Some of the off-balancing financing items include; joint ventures and operating leases. Woolworth and Wesfarmers can opt to overlook this financing technique in respect to disclosing their respective development expenditures as R&D activities (Ryan, 2006). Some of the ratios that will be affected by this financing model are calculated as follows; I) Debt-to-equity ratio For Wesfarmers; 2011=4,879/25,329=0.19 2012=5,502/25,627=0.21 2013=1,187/26,022=0.05 For Woolworth; 2011=4,844.9/7,845.8=0.62 2012=4,749.7/8,446.3=0.56 2013=4,451.9/9,300.5=0.48 Both of these companies depict a debt-to-equity ratio that decreases with the progression of operational years. Thus, they should continue with this form of financing since it keep the leverage ratios at a lower level hence being protected from the effects of disclosing negative contracts within its General Purposes Financial Reports (Ryan, 2006). References List Ashton, D. 2011. Residual income valuation models and inflation. The European Accounting Review, 20(3), 459-483. Penman, S.H., 2004, Financial Statement Analysis and Security Valuation, McGraw Hill. Pelepu, Healy and Bernard, 2004, Business Analysis and Valuation, 3rd Edition, Thomson Press. Ryan, B, 2004, Finance and Accounting for Business, Thomson Learning. Ryan, B, 2006, Corporate Finance and Valuation, Thomson Learning. Read More