TheImex Computer Company has completed its fiscal year on December 31. 2010. The
ID: 2376030 • Letter: T
Question
TheImex Computer Company has completed its fiscal year on December 31. 2010. The auditor Sandra Blake, has approached the CFO, Travis Williams, regarding the year-end receivables and inventory levels of Imex.
The following conversation takes place:
Sandra: We are beginning our audit of Imex and have prepared ratio analysis to determine if there have been significant changes in financial position. This helps us guide the audit process. This analysis indicates that the inventory turnover has decreased from 5 to 2.8, while the accounts receivable turnover has decreased from 12 to 8. I was wondering if you could explain this change in operations.
Travis: There is little need for concern. The inventory represents computers that were unable to sell during the holiday buying season. We are confident, however, that we will be able to sell these computers as we move into the next fiscal year.
Sandra: What gives you this confidence?
Travis: We will increase our advertising and provide some very attractive price concessions to move these machines. We have no choice. Newer technology is already out there, and we have to unload this inventory.
Sandra: and the receivables?
Travis: As you may be aware, the company is under tremendous pressure to expand sales and profits. As a result, we lowered our credit standards to our commercial customers so that we would be able to sell products to a broader customer base. As a result of this policy change, we have been able to expand sales by 35%.
Sandra: Your responses have not been reassuring to me.
Travis: I'm a little confused. Assets are good, right? Why don't you look at our current ratio? It has improved, hasn't it? I would think that you would view that very favorably.
Why is Sandra concerned about the inventory and accounts receivable turnover ratios and Travis' responses to them? What action may Sandra need to take? How would you respond to Travis' last comment?
Explanation / Answer
USE AS GUIDE!
Sandra is concerned about the inventory and accounts receivable turnover ratios as both these ratios have decreased from 5 to 2.8 and from 12 to 8 respectively. Both these ratios are an indirect measurement of the profitability of the firm. Higher the turnover ratios imply higher the profits as the company is able to work with less inventory and receivables. This indicates that fewer funds are tied up in these current assets and they can be deployed elsewhere to earn higher profits. The reduction in these ratios indicates that the firm is now working with higher amounts of current assets which in turn are compromising on the profitability. This is a cause of concern to Sandra.
Travis seems to be least worried about the decline in these ratios and in fact is sitting on a large stock of inventory which he is confident that he will be able to sell by increasing the advertising expenses and offering price concessions to customers. But what Travis isn%u2019t concerned about is that with increase in advertising expenses and concessions costs will shoot up bringing down profits. Also to improve sales they have slackened the credit policy which has resulted in huge receivables.
Sandra may need to ask Travis to unload inventory quickly so that the storage costs can be cut down and also mainly because of the new technology any delay could result in further loss. She may also ask Travis to improve credit management process by improving collection of receivables and trying to strike a right balance between additional sales and profitability loss due to high receivables. She will have to ask Travis to balance between liquidity and profitability as a high liquidity will eat into the profits of the firm.
Travis%u2019s last comment that the current ratio has improved seems to be quite favorable to him. He is of the feeling that high liquidity indicates an ease in paying of current liabilities but what he fails to realize is that excess of liquidity is not very good as it is at the cost of profitability. Any firm must trade a right balance between liquidity and profitability.
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