Analysis by Trial Balance-Part II

In analysis by trial balance, there is more than one way to discover what has happened to a firm's financial position since its last balance sheet and income statement were issued. We now consider the break-even inventory procedure of trial balance analysis.

The method of trial balance analysis we last considered is usually referred to as the "maintained gross profit procedure." This involves the construction of an interim balance sheet, and its accuracy depends largely on how precisely you are able to estimate the firm's gross profit percentage during the period covered by the trial balance. In assets where gross profit is difficult or impossible to estimate, another method is more suitable. This is called "break-even inventory procedure."

The logic of this procedure is quite simple: If the firm being analyzed has maintained the net worth it had at the start of the trial balance period, the sum of that net worth plus the new liabilities shown in the trial balance must equal total assets. Of course, the inventory as of the trial balance date is not given. But when the assets that are listed are subtracted from the sum of the beginning net worth and the liabilities, a figure is obtained that is the equivalent of the inventory needed to produce neither a gain nor a loss in the net worth for the period. By comparing this "break-even" figure with a rough count of the amount of inventory on hand, you can get a fair idea of how the firm is doing.

In the March 31, 19_, trial balance of the Robb Company, the previous financial statement had been issued three months before at the end of the preceding year. To determine the break-even inventory you would first total up the liabilities and net worth:

Accounts Payable      $12,000 
Notes Payable-Bank      3,000 
Reserves                      
Net Worth                   20,000 
Total                          $37,000 

Next you total up the listed assets:

Cash                                   $1,000 
Accounts Receivable          21,000 
Machinery and Fixtures       5,000 
Total                                 $27,000 

Then by subtracting the assets from the sum of the liabilities and net worth you get the break-even inventory figure ($37,000 - $27,000 = $10,000):

Cash                                $1,000           Accounts Payable      $12,000 
Accounts Receivable       21,000          Notes Payable-Bank      3,000 
Machinery and Fixtures     5,000          Reserves                       2,000 
Total                              $27,000          Net Worth                    20,000 
Break-Even Inventory      10,000          Total                          $37,000 
Total                              $37,000  


And when inserted into the cost of goods sold section of the Robb Company's March 31 income statement, the break-even inventory figure is such that there can be neither profit nor loss:

Net Sales                                             $17,000 
Inventory (12/31 of preceding year)   $16,000  
Plus: Purchases -Materials                      7,000  
-Supplies                                                 1,000  
Wages                                                     1,000  
Total                                                    $25,000  
Less: Break-Even Inventory                  10,000  
Cost of Goods Sold                              $15,000 
Gross Profit                                           $2,000 
Office Salaries                                         1,000 
Miscellaneous General Expense              1,000 
Total                                                      $2,000 
Net Profit                                                     -0- 


If you find that, in making your rough count of the company's inventory, its value is more than $10,000, you can assume that progress is being made; if it is less than $10,000, you have spotted trouble-the company's financial position having declined since its last balance sheet was issued.