You run a company that makes gourmet food for pot-bellied pigs. You have $1 million of finished product in inventory...just bags and bags of feed sitting in your warehouse. You estimate that 5% of this inventory will eventually spoil without getting sold.
To recognize this fact on your books, you have to record an inventory reserve of $50,000 (0.05 x 1,000,000 = $50,000). The figure provides a quantified monetary version of your expectation that some amount of inventory will eventually go bad. That number represents the inventory reserve. You're setting aside (on your financial statements at least) some money, in anticipation of the fact that you'll end up having to eat the value of the spoiled inventory. (Hopefully, you don't end up literally having to eat the inventory. Even gourmet slop is still...slop.)
Inventory reserves are the accounting mechanism to account for inventory that will lose value in the future. This situation can happen for any number of reasons...spoilage, aging or obsolete products, or some change in the market (like...pot-bellied pigs are identified as carriers of the plague, and people stop keeping them as pets).
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![Finance: What are Return on Equity and Return on Assets?](https://media1.shmoop.com/video/thumbnails/COURSE.FINANCE.176_770x433.jpg)
Finance: What are Return on Equity and R...145 Views
finance a la shmoop. what are return on equity and return on assets? all right
return on equity ROE .what is it? and no it's not that stuff that they stick on [sushi on a plate]
the outside of sushi. it's the kissing cousin of ROA if that helps. so what
is return then in this instance huh? well it's just profits. and there's a broader
frame here to think about. if your company just made five million dollars
in profits, was that good bad middlin? well if you were a little lemonade stand
that took 50 grand to start last year and you've made this massive five
million dollar haul well then yeah wow that's awesome. but if you're Google and
this year you only made five million bucks well you have tens of billions of
dollars of capital out there trying to earn lots more while making only five
million was a huge fail. so these concepts revolve around the balance
sheet remember this thing well here are assets, and if your General Electric the [balance sheet shown]
asset side is enormous. say with the notional fifty billion dollars in assets
if you made a ten percent return on your assets or raw ROA
return on assets well that would mean you netted five billion dollars right?
ten percent of 50 billions five billion. your return on assets was ten percent [math equation shown]
there. so remember equity or shareholders equity or retained equity on the balance
sheet yeah this thing right here what equity is the retained profits after
you've started to build your company and after years and years of building your
company you would expect to have a lot of retained earnings. so what were the
returns on that equity or ROE only returns or profits number is the same as
it was in the ROA calculation only now in the denominator we have equity so if
your returns were say five billion and your retained equity was twenty billion [equations shown]
well you had a lovely twenty five percent return this year. twenty five
percent of twenty billion you know five billion. meaning that in just this one
year you grew your retained equity one massively. you've become a big harvester [man lifts weights]
of cash profits from whatever great business it is that you built. well why
do we care about ROA and ROE? well because capital efficiency
matters. it's a reflection of how efficient you are, how well you're
investing your capital how will you're able to grow the business. that is in
theory you could just sell your assets and go invest them elsewhere, like go
play an index fund in the stock market, and potentially return better profits
for your shareholders, and if you can do that well then you're probably going to
get fired. and there is precedent for this change .the airline industry there [airplane taking off]
was a time when American Airlines and United Airlines and crash Airlines owned
all their airplanes. they bought them at 50 million bucks a pop give or take but
the airline industry is a lousy business producing very low cash profits. every
time the economic cycle is good the economy is good people are buying
airline tickets up the wazoo, the Union strike and the airline's try to do
stupid things with pricing and a bunch of other things happen and all the
profits go away. anyway so one day a smart MBA employed by the airline said
hey dudes why don't we just lease the airplanes from Boeing or whoever makes [man speaks to group]
them and we only need a fraction of our assets or equity or capital to produce
about the same investment returns for our shareholders. yeah and that's what
they did. so most airlines these days don't own
their own planes they lease them from the manufacturer or others and well
there haven't been any airline bankruptcies lately. and yes the airline
industry hard to find a better success story. [plane takes off]
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