Introduction:
Inventory is the largest asset for most firms. A 1985 Australian study by Gilmour found that inventory costs averaged slightly over 7 percent of sales. Inventories can account for 20 percent or more of total assets and over 10 percent of total sales.
Inventory carrying costs range between 20 and 40 percent of the value of product. In the United States, improved inventory management has led to the decrease in the ratio of inventory to gross national product from 20 percent in 1974 to under 50 percent in 1994.
The DuPont model:
Inventories influence a firm’s financial performance in at least two ways:
1. Net profit margin and,
2. Return on assets or return on investment (ROI). This influence can be seen using the DuPont analysis. (Figure 1.1 and 1.2). The numbers found in tables show how inventory affects financial performance. Several ratios in the DuPont model should be defined and explained first.
Net profit:
Net profit as the percentage of sales measure how efficiently and effectively products are manufactured and sold. However, net profit is not a true measure of performance. How well assets are used in creating profitability should also be measured.
Asset turnover:
Asset turnover, sales divided by total assets, shows how efficiently and effectively assete are employed to generate a level of sales. The higher the turnover, the better the assets are being used.
Return on assets:
Return on assets or return on investments (ROI) is determined by multiplying net profit margin by asset turnover. This ratio relates profitability to the value of the assets used. It is considered the best yardstick to measure performance because assets are difficult to manipulate. Selling and buying assets to change the ration normally requires too much money to be practical or easily done. The higher the ratio, the better the profitability.
Financial leverage:
Financial leverage is calculated by dividing total assets by the firm’s net worth. It measures how management employs outside financing to increase returns on net worth. There is absolutely nothing wrong with using other people’s money to grow and prosper. However, there is a point at which a firm is too leveraged. This leads to higher dividend payouts, increased interest payments on debt, and possible financial ruin.
Inventory is the largest asset for most firms. A 1985 Australian study by Gilmour found that inventory costs averaged slightly over 7 percent of sales. Inventories can account for 20 percent or more of total assets and over 10 percent of total sales.
Inventory carrying costs range between 20 and 40 percent of the value of product. In the United States, improved inventory management has led to the decrease in the ratio of inventory to gross national product from 20 percent in 1974 to under 50 percent in 1994.
The DuPont model:
Inventories influence a firm’s financial performance in at least two ways:
1. Net profit margin and,
2. Return on assets or return on investment (ROI). This influence can be seen using the DuPont analysis. (Figure 1.1 and 1.2). The numbers found in tables show how inventory affects financial performance. Several ratios in the DuPont model should be defined and explained first.
Net profit:
Net profit as the percentage of sales measure how efficiently and effectively products are manufactured and sold. However, net profit is not a true measure of performance. How well assets are used in creating profitability should also be measured.
Asset turnover:
Asset turnover, sales divided by total assets, shows how efficiently and effectively assete are employed to generate a level of sales. The higher the turnover, the better the assets are being used.
Return on assets:
Return on assets or return on investments (ROI) is determined by multiplying net profit margin by asset turnover. This ratio relates profitability to the value of the assets used. It is considered the best yardstick to measure performance because assets are difficult to manipulate. Selling and buying assets to change the ration normally requires too much money to be practical or easily done. The higher the ratio, the better the profitability.
Financial leverage:
Financial leverage is calculated by dividing total assets by the firm’s net worth. It measures how management employs outside financing to increase returns on net worth. There is absolutely nothing wrong with using other people’s money to grow and prosper. However, there is a point at which a firm is too leveraged. This leads to higher dividend payouts, increased interest payments on debt, and possible financial ruin.