Question

Your company had the following balance sheet and income statement information for 2003:

Balance sheet:

Cash                                        $    20

A/R                                         1,000

Inventories                           5,000

Total C.A.                              $ 6,020                       Debt          $ 4,000

Net F.A.                                  2,980                        Equity          5,000

Total Assets              $ 9,000                       Total claims $ 9,000

Income statement:

Sales                                       $10,000

Cost of goods sold    9,200

EBIT                                       $   800

Interest (10%)                         400

EBT                                         $   400

Taxes (40%)                             160

Net Income                           $   240

The industry average inventory turnover is 5. You think you can change your inventory control system so as to cause your turnover to equal the industry average, and this change is expected to have no effect on either sales or cost of goods sold. The cash generated from reducing inventories will be used to buy tax-exempt securities which have a 7 percent rate of return.

What will your profit margin be after the change in inventories is reflected in the income statement?

Answer 1

1. Current Inventory = $5000

2. New Inventory proposed = Cost of goods Sold / average inventory turnover

New Inventory proposed = 9200 / 5

New Inventory proposed = $1840

3. Cash generated from proposed plan = Current Inventory - New Inventory = 5000 - 1840 = $3160

4. New Profit after changed Inventory policy = Current Net Income + Cash generated * Interest rate

New Profit after changed Inventory policy = 240 + 3160 * 7%

New Profit after changed Inventory policy = $461.20

5. profit margin = New Profit / Sales

profit margin = 461.20 / 10000

profit margin = 4.612%