Impact of Inventory Error on Ratio Analysis

Financial analysts use various ratios using financial statements to analyse the financial condition of the company. Ratio analysis can provide understanding about liquidity, efficiency of operations, and profitability. Ratio analysis can be used in two ways:

1. Trend line. Trend line provides important analysis about company’s performance in longer period. Change in ratio in a longer period helps comparing the different aspects of statements.
2. Industry comparison. Companies in a particular industry have similar financial structure and similar ratios. Comparing the rations with industry average can provide useful insights about the company’s performance.

There are several hundred possible ratios that can be used for analysis purposes, but we will just see the impact of inventory error on a small core group of ratios. Overstatements of ending inventory result in understated cost of goods sold, overstated net income, overstated assets, and overstated equity. The ratios affected by these include:

Current ratio. It is used to see if a business has enough cash to pay its immediate liabilities [1].

1. Current ratio = current assets / current liabilities
2. Inventory is part of current assets and therefore higher than actual inventory will reflect higher current ratio.
3. This will provide wrong information to the investors about the company’s ability to cover current liabilities.
4. Debt to equity ratio. It is a measure of  business’s capacity to pay its debt with equity [1].
   1. D/E ratio =Total liabilities / Total equity
   2. Inventory error in our case would reduce cost of goods sold. This in turn would increase net income and therefore higher equity. This would lower the D/E ratio. Low D/E ratio is a favourable condition which would misguide the investors.
5. Dividend payout ratio. It is the percentage of earnings paid to investors in the form of dividends. If the percentage is low, it is an indicator that there is room for dividend payments to increase substantially.[1]
   1. Assuming that the board of directors doesn’t know about the accounting errors, it might result on higher dividend payout.
6. Inventory turnover. Calculates the time it takes to sell off inventory. A low turnover figure indicates that a business has an excessive investment in inventory, and therefore is at risk of having obsolete inventory [1].
   1. High inventory in our case would result in low inventory turnover ratio. This can raise some concern in the investor’s mindset about company’s operation.
7. Net profit ratio. Calculates the proportion of net profit to sales; a low proportion can indicate a bloated cost structure or pricing pressure [1].
   1. High inventory in our case would result in high net profit ratio. This will provide incorrect information to the investors.
8. Price to earnings ratio. Compares the price paid for a company's shares to the earnings reported by the business [1]
   1. P/E ratio = price per share / Earnings per share
   2. In our case, P/E ratio will decrease due to higher earnings (based on lower COGS) but it may trigger a positive response from investors and price may go up. This movement would be based on false information provided by the company. When company would try to correct the error, this ration will go excessively high which is an indication of overvalued stock. 
9. Return on assets. Calculates the ability of management to efficiently use assets to generate profits. A low return indicates a bloated investment in assets [1].
   1. ROA =  net income / total assets
   2. There would be no change in the ROA as net income and assets would be affected by same amount in our case.

Taxation Problems:

In our case high inventory would have 2 effects on taxes

1. We have already seen that the practice followed by Better buy would reduce the COGS (Cost of Goods Sold). This means that higher net income and therefore higher taxes. This means that the company is giving away higher taxes just due to inappropriate accounting method.
2. Higher inventory means higher storage and handling expenses. In merchandising industry, it is one of the most important cost factors. Therefore net income goes down due to in appropriate operations.

 The Matching principle

According to matching principle is an accounting principle, businesses recognize revenues in the same accounting period as the expenses. Using the LC/NRV rule, businesses can be sure that they report expenses for, say, loss of inventory value, in the same period they report revenues from sales of that inventory. In our case, this principle is also overlooked and thereby manipulating the financial statements [2].

 The Conservatism Principle

GAAP in most countries incorporates the conservatism principle. According to this, the inventory cost should be calculated based on lowest possible value. In case of better buy, the company calculated the value of returned or damaged inventory at the same value as new one. This is not at all in accordance with conservatism principle [2].

Real world Case Study

DHB industries vs Securities and Exchange commission (October 2007) [3]: DHB industries is a major supplier of body armour to US military and armed forces. SEC (Securities and Exchange Commission) lodged a complaint against DHB of being engaged in fraudulent accounting practices, systematically looting company’s coffers and took advantage of inflated stock prices.

Founder of DHB industries, along with his chief finance officer, manipulated the company’s gross profit margin and net income by overstating DHB’s inventory values and falsifying journal entries. Based on this, company’s share price reached all time high. At the same time, Founder sold his shares for approx 186 million$ while he was aware about the material and non public information about the company’s accounts. 

References:

1. https://www.accountingtools.com/articles/ratio-analysis.html#:~:targetText=Ratio%20analysis%20is%20the%20comparison,efficiency%20of%20operations%2C%20and%20profitability.&targetText=Ratio%20analysis%20is%20particularly%20useful,Trend%20line.
2. https://www.business-case-analysis.com/lower-of-cost-or-market.html
3. https://www.sec.gov/litigation/complaints/2007/comp20345.pdf