Student Forums CMA Part 1 Section B: Planning, Budgeting and Forecasting B.6. Top-Level Planning and Analysis Question ID: HOCK CMA.P1A5.11 (Topic: Top-Level Planning and Analysis)

# Question ID: HOCK CMA.P1A5.11 (Topic: Top-Level Planning and Analysis)

• Creator
Topic
• #228385
Aaron Yu
Participant

Hi,

I am a bit confused by this question. If we are to match the inventory ratio to the industry average, thus reducing inventory from \$20,350 to \$18,205 and with a corresponding increase (i.e. \$2,145) to cash. Wouldn’t this change leave the total assets unchanged at \$125,650?

And if the total assets stays unchanged, wouldn’t that keep the “additional funds needed” the same at \$938? (since Total Liabilities & SE stayed the same)

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• #228388
Lynn Roden
HOCK international

Hello Aaron Yu,

That is a very thoughtful question. This take some imagination, so I have put it on an Excel spreadsheet for you, and it is attached.

Remember that assets must equal liabilities plus equity. Thus, we first assume that the company does borrow that \$938 in additional funds that it needs (because it must do that in order for its assets to balance with its liabilities & equity). That amount is added to notes payable, and notes payable on the balance sheet becomes \$10,938. Total assets equals total liabilities & equity, and both are \$125,650.

Next, we assume the \$2,145 in additional cash becomes available from inventory. Total current assets remains the same at \$47,850, total assets remains the same at \$125,650, and total liabilities & equity remains the same at \$125,650.

Next, the \$2,145 is used to pay down the \$10,938 note payable so that the note payable has a balance of \$8,793. Total assets becomes \$123,505 and total liabilities & equity becomes \$123,505.

The note payable balance of \$8,793 is \$1,207 less than the original forecast of \$10,000, and the company’s cash is the same at \$10,670. So instead of needing to borrow \$938, the company has been able to pay down its note payable by \$1,207 as a result of drawing down its inventory by \$2,145.

Does that help?

Lynn

#228391
Aaron Yu
Participant

Hi Lynn,

Yes, this is great. Thanks so much for the clarification.

Aaron Yu

#230244
Darryl Briones
Participant

Is COGS always the one to remain the same level when inventory turnover ratio has to change? I tried approaching this problem by changing the COGS amount while keeping Inventory at the same level but honestly, I got nowhere near any of the answer choices.

#230258
Lynn Roden
HOCK international

Hello Darryl,

The Inventory Turnover Ratio is primarily a means of controlling the level of inventory so that it does not get too high or too low. A company needs to have enough inventory to support its sales without letting the inventory level get too high. If the level of inventory gets too high, the company will have money tied up in inventory that is just sitting there and not working for the company, when instead it could use the money invested in the excess inventory for something else.

So to answer your question, yes. If the inventory turnover ratio is too low, that means inventory is too high. The inventory on hand has already been purchased and the cost of goods sold is the cost of the inventory that has been sold. The company cannot change that. The company can, however, reduce its future purchases of inventory so that for a while, it will be selling more than it is purchasing, until its level of inventory comes down so that its inventory turnover ratio will increase. Because purchases will decrease, cash that would otherwise have been used for more purchases will be freed up. And then going forward, it can work to keep its purchases more in line with its needs.

Now, if inventory is too high because the company has a lot of obsolete inventory on hand that cannot be sold, that is a different problem. Inventory should be carried at the lower of its cost or its net realizable value. So if the company has inventory that has decreased in value because of obsolescence or other reasons, it should write the value of the inventory down and take a loss. There is no indication that that is the case in this problem, but it is something that management should be mindful of.

Lynn

• This reply was modified 4 months, 2 weeks ago by Lynn Roden.
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