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14. Financial Statement Analysis

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Ratios: Average Days in Inventory

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a lot of times when we use our inventory turnover ratio, we use a related ratio called the average days in inventory. Let's check it out here. So average days in inventory, remember it's gonna be related to that inventory turnover ratio? Well the average days in inventory, it helps us analyze how long a unit sits in the warehouse before being sold. Okay. So this is this is literally gonna be amount of days that we're thinking about, that the units sitting in the warehouse. So this average days in inventory, it's another common efficiency ratio similar to the inventory turnover ratio. Cool. So it's an efficiency ratio to see how efficiently we're using our inventory balance. So remember that holding inventory costs us money so the longer that a unit sits in the warehouse, well that's gonna cost us money and renting the warehouse and paying utilities in the warehouse, whatever it is, there's gonna be all sorts of expenses related to having inventory. So imagine the more and more inventory we have, the bigger warehouse we need, the more we're gonna need to spend on it. So like I said this average days in inventory, it's related to the inventory turnover. And let's just go over that inventory turnover ratio real quick before we move on to the average days and inventory. Now there was a whole discussion on the inventory turnover ratio. So make sure that you understood that and then move on here with the average days and inventory. So remember we calculated inventory turnover, we had the cost of goods sold divided by our average inventory, right? And we always calculate average balances in all cases, it's always gonna be for any sort of average anytime we have an average uh balance of an account. So average inventory, average accounts receivable, average whatever it is, we're gonna take the beginning balance in that account plus the ending balance in that account and divide it by two. Right? Let me do it as a fraction here divided by two. Right? That's always gonna be how we calculate average. So in this case average inventory beginning inventory plus ending inventory divided by two. So notice when we go to calculate our average days and inventory. Well all we do is we take our inventory turnover ratio and we're gonna do 3 65 divided by that ratio. Okay, so that's easy enough. Right? And notice that this average days in inventory just like it says average days in inventory. It tells us how many days how many days a unit sits in inventory. So it's gonna be a number of days this year. On average we buy a unit and it sits there for 20 days before we sell it. Right? So you can imagine that a company wants to sell these things as fast as possible, they want to a unit to come into inventory and we sell it right away to make that money. So how do we compare average days in inventory? We'll just like a lot of other ratios, we're gonna use benchmarking, right? We want to compare to our industry, you can imagine different industries are gonna have different days in inventory right? Sometimes they're gonna have to sit there for a while before they get sold. Sometimes things move really quickly. So we want to see how our competitors do in their average days in inventory as well as maybe just an industry average for this kind of number and then compare how our company is doing. Okay? So what do you think would a higher amount of days in inventory or a lower amount of days in inventory be more efficient? A lower amount of days, right? That's what we want. We want to be able to buy a unit and sell it immediately. We want a low amount of days in inventory. And that means that we're turning our inventory really fast. So just like the inventory turnover, it's kind of uh related to it in a reciprocal fashion where we want to be able to turn over our inventory many times. Well that means we're selling it quickly and we're gonna have a low average days in inventory. So that's how these are kind of interrelated there. So why don't we move on to this example and see how we use the average days and inventory in practice. Let's try this example together. X. Y. Z. Company had net sales of 500,000 and cost of 320,000 if the beginning balance of inventory was 60,000 and the ending balance in inventory was 100,000. What is the average days in inventory? So the first thing we wanna do is calculate our inventory turnover ratio. Right this is gonna be a two step process. We calculate our inventory turnover ratio and then we do the 3 65 divided by that ratio. So let's go ahead and do that. So remember when we do our inventory turnover ratio notice above, we don't talk about net sales at all. That's extraneous information, we don't need that. So let's go ahead and use what we do need our cogs for our numerator and our average inventory balance. So the first thing we wanna do is that average inventory balance. And remember that's just beginning plus ending divided by two. So what we got 60,000 Plus 100,000 and we divide that by two. And that is going to be our average inventory 160,000 divided by 2 80,000 is our average inventory balance. Right? So let's go ahead and finish up our inventory turnover ratio before we get to our our average days in inventory. So inventory turnover. Well what do we got? We're gonna have our numerator of 320,000 Our denominator of 80,000. Right cogs over average inventory. And that gives us an inventory turnover ratio of four point oh right four on the dot. So the last thing we gotta do is calculate our average days in inventory. So let's do that in blue since this is the big payoff right here, average days in inventory. So here we go. How do we do it? Very simple, right? 365 in our numerator and in our denominator is our inventory turnover, which was just four in this case, right? four. We just solved it above 365 divided by four. We'll notice they didn't do any decimals here, so we're gonna round it, it's approximately 91. So remember this is a number of days, right? This is a number of days. So what does that mean? We buy a unit into our inventory and it's gonna sit there for 91 days for three months before we sell it. Cool. So 91 days. That's our answer in this case C. Is the answer. Alright. Cool. Let's go on to the next one and you guys try and calculate the average days and inventory. Alright let's do that now.

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Problem

ABC Company had $200,000 in Net Sales and Gross Profit of $80,000. If Inventory had a balance of $60,000, what is the company’s average days in inventory ratio?

A

274 days

B

182 days

C

110 days

D

Not enough information

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