Inflation can have significant effects on income statements and balance sheets, and therefore on the calculation of ratios. Discuss the possible impact of inflation on the following ratios, and explain the direction of the impact based on your assumptions.
b. Inventory turnover
If the company uses the LIFO method, inflation will overstate the turnover ratio. If the company uses the FIFO method, inflation may understate the ratio.
First In, First Out (FIFO) is a method of accounting where assets acquired first are disposed of first.
When an organization uses the FIFO method during inflation, the cost of goods sold decreases, and the lower cost of goods sold results in a lower inventory turnover ratio.
Last In, First Out (LIFO) is a method of accounting where assets acquired last are disposed of first.
When an organization uses the LIFO method during inflation, the cost of goods sold increases, which would result in higher inventory turnover ratios.
The Haines Corp. shows the following financial data for 20X1 and 20X2:
Cost of goods sold
Selling and administrative expenses
Income before taxes
Income after tax
For each year, compute the following and indicate whether it is increasing or
decreasing profitability in 20X2 as indicated by the ratio:
a. Cost of goods sold to sales.
Identify whether each of the following items increases or decreases cash flow:
Increase in accounts receivable
Decrease in prepaid expenses
Increase in notes payable
Increase in inventory
Increase in investment
Increase in accrued expenses
Decrease in account payable
Using the income statement for Times Mirror and Glass Co., compute the following ratios:
The total assets for this company equal $80,000. Set up the equation for the Du Pont system of ratio analysis, and compute c, d, and e.
e. Return on assets (investment).
Times mirror and glass company
Less: Cost of goods sold
Less: selling and administrative expenses
Less: Interest expenses
Earning before taxes
Less: Taxes (30%)
Earning after taxes
*equal income before interest and taxes
Arrange the following items in proper balance sheet presentation:
Plant and equipment – original cost
Allowance for bad debts
Common stock, $1 par, 100,000 share outstanding
Preferred stock, $59 par, 1,000 share outstanding
Capital paid in excess of par (common stock)
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