Financial Accounting: In an Economic Context

ROE EXERCISE: MANAGEMENT OF INVENTORY AND RETURN ON EQUITY

The ROE model, introduced and illustrated in Appendix 5A, provides a framework linking the management of a company's operating, investing, and financing activities to its return on the shareholders' investment (return on equity). The management of inventory plays an important role in the ROE model primarily through the inventory turnover ratio. Recall as well that inventory is a current asset, so inventory management also influences working capital and the current ratio, discussed in Chapter 6.

Inventory Turnover

Inventory turnover (cost of goods sold ÷ average inventory) provides a measure of the level of a company's investment in its inventories. For retailers, adequate inventory levels must be maintained to properly service retail customers; for manufacturers, adequate levels of raw materials, work in process, and finished goods must be maintained to support the manufacturing process. Yet, inventories must be financed at a cost and they take up costly space, indicating that carrying overly high levels of inventories is not in the best interest of the shareholders. In terms of the ROE model, inventory turnover is a component of total asset turnover, meaning that changes in inventory turnover are reflected in changes in asset turnover, which in turn are reflected in return on assets (ROA), which in turn are reflected in return on equity (ROE). Thus, increasing inventory turnover (decreasing the investment in inventory ...