Rodgers Industries Inc. has completed its fiscal year on December 31, 2014. The

Question

Rodgers Industries Inc. has completed its fiscal year on December 31, 2014. The auditor, Josh McCoy, has approached the CFO, Aaron Mathews, regarding the year-end receivables and inventory levels of Rodgers Industries. The following conversation takes place: Josh: We are beginning our audit of Rodgers Industries and have prepared ratio analyses to determine if there have been significant changes in operations or financial position. This helps us guide the audit process. This analysis indicates that the inventory turnover has decreased from 5.1 to 2.7, while the accounts receivable turnover has decreased from 11 to 7. I was wondering if you could explain this change in operations. Aaron: There is little need for concern. The inventory represents computers that we 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. Josh: What gives you this confidence? Aaron: 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. CENGAGE LEARNING Chapter 17 Financial Statement Analysis 831 Josh: … and the receivables? Aaron: 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%. Josh: Your responses have not been reassuring to me. Aaron: 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 Josh concerned about the inventory and accounts receivable turnover ratios and Aaron’s responses to them? What action may Josh need to take? How would you respond to Aaron’s last comment?

Explanation / Answer

1. Impact of Decreased Receivable Turnover Ratio and Actions to be taken

The receivables turnover ratio measures a business' ability to efficiently collect its receivables, it only makes sense that a higher ratio would be more favorable. Higher ratios mean that companies are collecting their receivables more frequently throughout the year. If a company can collect cash from customers sooner, it will be able to use that cash to pay bills and other obligations sooner. Higher Ratio is also important since accounts receivable are often posted as collateral for loans, quality of receivables is important.

Josh Analysis indicates that the Accounts Receivable Ratio has decreased from 5.1 to 2.7. This means that Company now collects his receivables about 2.7 times a year or once every 135 days as compared to previous data 5.1 times a year or once every 72 days.

Actions to be taken by Josh to improve Receivable Turnover Ratio

2. Impact of Decreased Inventory Turnover Ratio and Actions to be taken

Inventory Turnover Ratio measures how many times average inventory is turned or sold during a period. In other words, it measures how many times a company sold its total average inventory dollar amount during the year

Josh Analysis indicates that the Inventory Ratio has decreased from 11 to 7. This means that company sells its inventory 7 times over the year as compared to previous data 11 times that means company sold inventory 11 times over a year, which results in higher storage costs and holding costs.

Actions to be taken by Josh

There are several ways in which the inventory turnover ratio can be improved

Conclusion

Aaron should work towards increasing its debtor’s turnover ratio and Inventory Turnover Ratio which eventually will lead to all sales converting to cash sales and negligible or very little credit sales and decreasing Storage Cost and Holding Cost.

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