tract. So, it could be based on billings, partial deliveries, percentage of completion, or any other method the company felt was appropriate.
● Other long-term contracts– the method used should be determined by the circum- stances of the project. The percentage-of-completion method would usually be used where the cost estimates and the progress valuation are reasonably reliable. Otherwise the completed contract method should be used.
In Canada long-term contracts can be recognised on a percentage-of-completion basis, as long as it relates appropriately to the work that has been done. The completed contract basis would only be appropriate if either of the following applied:
● the performance consists of the execution of a single act;
● the company cannot reasonably estimate the extent of the progress towards completion.
● THE STOCK RATIOS
As stock is so important to the reported results of a company, we have evolved a number of different ways of assessing a company’s control of stock. Companies need to keep a certain level of stock to ensure that their business runs efficiently and so that they can satisfy demand for their products. Managing stock is a balancing act; the company wants to have sufficient stock, but also it wants to minimise its investment in stock. Tying up money in stock can be costly, not only in interest charges, but also in lost opportunities. The company may get a bet- ter return investing in fixed assets, or even just placing the money on deposit. All companies try to optimise their investment in stock, having just enough to satisfy demand. The amount of stock a company needs is determined largely by the nature of its business. Large grocers, with sophisticated information systems, can predict demand on a daily basis, whereas for other companies demand can only be predicted annually. Therefore, we need to understand a com- pany’s business if we are to understand its stock. However, we can find out useful information from the accounts. We can find out if the company we are analysing is carrying more or less stock than it used to; or more or less stock than other companies in its sector. If the stock is changing, We can discover what proportion of any change in stock has come from changes in the level of sales, and how much has come from changes in the company’s practices.
Once the company has achieved their optimum level, stock should be related to the com- pany’s sales in a period. If the sales double, it is not unreasonable to assume that the value of stock will double. There are two ways of measuring the company’s control of stocks. Either you can see how many times a year the company turns its stock over, or you can work out how many days’ stock the company is carrying. There are slightly different ways of making both calculations.
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Stockturn
This shows you how many times a year a company converts its stock into sales. Whilst the principle is simple, the calculation is open to debate.
Stocks relate to the merchandise that has been sold in the period for a retailer, and to the materials, labour and overheads used in sales for a manufacturer. Therefore, we would want to compare stocks with the materials that have been used. We do not necessarily have these figures available to us in the published profit and loss account. In the UK, only a Format 2 profit and loss account (unfortunately the least popular presentation) will give us this infor- mation. Even if we did have the information, manufacturing businesses will also include
direct labour and a proportion of overheads in their stock values. So, either way, we are unlikely to be able to get an accurate figure.
Some analysts would use cost of sales as an approximation to production costs, but this can mean different things to different companies. If you want to compare companies you need to look at stocks in relation to turnover. Although it is wrong, it is consistently wrong and enables you to compare one company with another! You must remember that you are only trying to identify whether the company has a problem, or a commercial advantage. You are always going to be unable to quantify anything accurately as the balance sheet has already been managed to give you the best view. We could use cost of sales if we were only analysing one company, as it probably more nearly reflects production costs. However, if we were comparing companies internationally, or within a sector, we would use turnover. Most people use turnover. Whichever way you choose to calculate stockturn, you should still get the same trend (unless profit margins have fluctuated wildly during the period), although not exactly the same answer as we shall see!
If we look at the stockturn calculation using both turnover and cost of sales as the numerator:
Turnover based Cost of sales based
Turnover Cost of sales
Stock Stock
To illustrate the stock ratios, we will calculate all the stock ratios using the following information:
Year 1 Year 2 Year 3 Year 4
Turnover 1000 1050 1150 1300
Cost of sales (400) (420) (450) (510)
Other operating costs (300) (310) (330) (350)
Operating profit (300) 320 370 440
Stock at the year end 100 110 125 150
We can see at a glance that the company is carrying its stock for longer. Sales in the period have risen by 30 per cent, and stocks by 50 per cent. Now we need to quantify the size of the problem. In our example the stockturn for the company would be:
Year 1 Year 2 Year 3 Year 4
Stock turn:
Turnover based 10 times 9.6 times 9.2 times 8.7 times Cost of sales based 4.0 times 3.8 times 3.6 times 3.4 times
You can see how using turnover, rather than cost of sales, has the effect of understating stocks. As this number is not calculated in a way that ensures its accuracy, it is important that it is looked at in context. Is the control of stocks improving, does this company have lower stocks than other companies in the sector?
It is also important to recognise that the way we calculate the ratio can affect the answer that we get.
Cost of sales as a percentage of turnover
We can see that the company is converting its stock into sales at a slower rate each year. The trend we show is exactly the same whether we use turnover or cost of sales, as the company’s cost of sales is at a fairly constant percentage of turnover:
EXAMPLE
Year 1 Year 2 Year 3 Year 4 Cost of sales as a
percentage of turnover 40.0% 40.0% 39.1% 39.2%
If it had not been fairly constant, we would have had a different trend for the turnover- based ratio compared to the cost-of-sales based ratio. But a changing cost of sales ratio could tell us something else about the company:
● there could be changes in the product mix, this may lead to changes in the required stock levels too;
● there could be changes in the costs that are not passed on to the customer;
● the company could be more, or less, efficient and is not passing on the effect of efficiency changes to its customers;
● if the cost of sales is falling, the company could be investing more in fixed assets to reduce costs and keeping the benefits for itself.
This list is far from exhaustive, but we should have information elsewhere in the accounts that may support one, or more, of the possibilities.
●
Stock days
Another way of looking at stock is to calculate how many days stock the company has at the year end. This tells us how many days of sales are currently being held as stock and is calcu- lated using one of the following formulas:
Turnover based Cost of sales based
..Stock.. x 365 ...Stock... x 365
Turnover Cost of sales
We are multiplying by 365 as we are looking at the sales for the year and the stock on a given day; 365 represents the number of days in the accounting period.
Using our earlier example, the stock days would be:
Year 1 Year 2 Year 3 Year 4
Stock days:
Turnover based 36.5 38.2 39.7 42.1
Cost of sales based 91.3 95.6 101.4 107.4
Over the four years the company’s stock levels have moved from 36.5 days (based on sales) to 42.1 days. The company is carrying much more stock than it used to, but does this really matter?
Using either stockturn or stock days we can calculate what the company’s investment in stock would have been, if the stock had been maintained at the previous years levels by using the formulas below:
Stockturn Stock days
..Turnover / cost of sales Turnover / cost of sales x previous year’s stock days Previous year’s stockturn 365
10 The stock ratios
Whether we use turnover or cost of sales, stockturn or stock days, we can calculate the extra investment that the company has had to have in stock. Different ways of calculating the investment will give slightly different answers, but the principle remains the same. The calculation of the additional investment is illustrated, using a turnover-based stockturn, in Table 10.2.
We know that the company is now holding more stock than it used to, and this has meant that it has had to have another 8.7 tied up in stock during year four. This is almost 6 per cent of the stock value for year four. Had the company been able to maintain stocks at the levels of year one, it would only have required 130 (based on turnover) or 127.5 ( based on cost of sales ) invested in stock. (If we use the turnover number, we eliminate the difference that has come from the reduction in the cost of sales as a percentage of turnover from 40 per cent to 39.2 per cent.) Every extra day the company holds its stock costs 3.56 (total stock of 150 number of days stock held 42.1). If the stocks could have been maintained at the same levels as the first year, the company would have had another 20 to invest elsewhere in the business.
We know that stocks appear to have increased, we now need to think about why this might have happened. Analysis is not about measurement, it is about understanding! A few of the possible reasons could be:
● The company could be forced to carry more stocks because the nature of their business has changed. Possible changes could be:
– a change in the mix of products that the company sells;
– its customer base may have changed;
– the market has become more volatile and it is more difficult to predict demand pat- terns.
● The volume of the stock may be unchanged, but the costs may have increased. This could be due to:
– negotiations with suppliers occur towards the end of the year, so the increased costs are reflected in stocks, but have yet to work through to sales. If we had the opportunity to question the company, we would simply ask that question, but we could check our guess by looking at stock in relation to the following year’s sales (we obviously cannot do this for the last year). This gives some interesting results with stock days (based on turnover) running at a fairly constant level of around 35 days;
– a combination of material cost increases and a competitive market where the company is unable to pass on the price increases. However, this does not fit well in our example, as we would expect the cost of sales as a percentage of turnover to be increasing, rather than falling.
● The company could be buying in larger quantities to get better prices. This should be reflected in falling cost of sales.
The investment in stock Table 10.2
Year 3 Year 4 Year 4 stock Additional
@ Year 3 investment in
stockturn stock
Turnover 1150 1300
Stock value 1,125 1,150 141.3 8.7
Stockturn 1,9.2 1,8.7
Base stock A method of stock valuation that values the minimum stock that a company must have in order to operate, at a fixed price. Any stock above this minimum would be valued dif- ferently.
Consignment stock Stock that is held by one party, but legally owned by another.
Current cost The lower of the net realisable value and the replacement cost.
First in, first out (FIFO) A method of stock valuation that charges the oldest deliveries to the profit and loss account, and shows the most recent deliveries as stock.
Last in, first out (LIFO) A method of stock valuation that charges the most recent deliveries to the profit and loss account, and shows the oldest deliveries as stock.
Net realisable value The selling price less any further costs to completion, sales, marketing and dis- tribution costs.
Percentage of completion A method of accounting for long-term contracts where turnover is recorded as the contract progresses, and profit is recorded as it arises. This means that contract work in progress is rarely shown in a company using this method to account for long-term con- tracts.
Replacement cost The cost of replacing the stock at the balance sheet date. It is used to determine the current cost of stock.
Standard cost A budgeted cost, based on detailed assumptions. This can be used for stock valua- tion as long as it is frequently reviewed and approximates to the actual cost.
10 The balance sheet: stock
When analysing a company we need to know whether any changes in its stocks have arisen from changes in sales or from changes in management practice. We should be able to spot changes in stock at a glance; ratios will help us measure them. We have two ratios that help us to measure any changes in stocks levels: stockturn and stock days.
Stockturn
This tells us how many times in the period the company has converted its stock into sales.
It is calculated by dividing either the turnover, or the cost of sales, by the stock. The higher the number, the shorter the conversion period.
Stock days
This tells us how many days sales (or cost of sales) are held in stock. The stock is divided by the turnover, or cost of sales, and then multiplied by the number of days in the accounting period.
Once we have identified a trend in the management of stocks, we should try to under- stand why the management practice may have changed. There will often be other infor- mation in the accounts that we can use to help us understand why the stock levels have changed.
SUMMARY
JARGON