Understanding Work-In-Progress (WIP) When Analyzing Financial Statements

Understanding Work-In-Progress (WIP) When Analyzing Financial Statements For someone with very little to no background in accounting or financial matters, making business decisions based on the results of reviewing and analyzing financial statements and other financial reports can be quite intimidating. In fact, that is the reason why you hear about a lot of company executives leaving the job in the hands of staff members who they think have the right qualifications and knowledge.For example, they’ll have their accountants do the reviewing â€" more formally, it is referred to as “financial statements analysis â€" and then have them interpret the results and make recommendations in layman’s terms. In short, in business language that they can understand.That’s all well and good, but don’t you think it would be better if you knew a little more about the basics of financial statements analysis? It doesn’t mean that you should know the often too intricate processes and methodologies of analyzing financial statements, but only to get the basic idea or the gist of things.To a certain extent, this will let you keep a handle on most things, maintaining a degree of awareness about how the business is really performing, instead of simply and blindly going along with what your accountants tell you. That way, you will also feel more confident in your decisions. Plus, it also minimizes the risks of you being swindled by those who advise you on these matters, and surely you want to make sure of that, don’t you?Granted, financial statements analysis is not something that can be easily learned. There are simply too many factors to consider and a lot of elements at play. One of the elements that often give rise to confusions in the review of financial statements is the Inventory account.It’s certainly not much of a problem in a merchandising concern where, often, there is only one type of inventory maintained. It becomes a bit complicated in a manufacturing concern, because there are several inventories to consider, mainly depending o n the stages of completion, including Finished Goods Inventory and Work-in-Progress.The confusion is definitely going to be greater if we also consider the Raw Materials Inventory and other inventories of indirect supplies and materials used in the production process.But don’t worry. We don’t want to overwhelm you with too much information all at once, so we’ll take things one at a time. By the end of this discussion, you will understand Work-in-Progress in the context of financial statements analysis. WHAT IS WORK-IN-PROGRESS?Work-in-Progress, or WIP, is a component of the Inventory account, which is reflected in the Asset section of the Balance Sheet (or the Statement of Financial Position). You may have seen other companies use the account title “Work-in-Process”. They’re the same thing.WIP is clearly different from the other types of inventory for manufacturing concerns. Raw Materials Inventory includes the direct materials that are still in their unaltered form, prior to being placed into production; WIP includes the materials that have been subjected to processing, regardless of the degree or extent. Finished Goods Inventory, on the other hand, includes those that have been completed, after undergoing the entire production process, and are now ready for sale; WIP are still unfinished and certainly not yet ready to be sold.Production Cost (or Manufacturing Cost) refers to the total costs put into the production or manufacturing process in order to complete products that have been partially worked on or completed. It includes all the costs that have been incurred at various stages of the production process, and has three elements:Raw materials, or the materials directly used in the production processDirect labor, or the wages of worker or staff directly involved in the production processAllocated overhead (e.g. indirect materials, indirect labor, and other overhead expenses, such as utilities and depreciation directly traceable to the production process)At the end of the reporting period, the amount corresponding to the cost of goods that have been placed into process, but are not yet completed, is the ending inventory of the WIP. This is the figure that will be included in the Inventory account presented in the Balance Sheet.But you have to be careful here. In financial statements analysis, the WIP may also refer to the portion of the total Production Costs that was actually used in the production process. Instead of an asset account, it will form part of the cost of goods manufactured, which will appear in the Income Statement. The formula to arrive at that figure is:WIP Inventory, beginning balanceXXXAdd: Costs put into process     Raw Materials UsedXX     Direct LaborXX     Factory OverheadXXTotal Production CostXXXLess: WIP Inventory, ending balance(XXX)WIP UsedXXXConfused yet? You’d understand this better if we go over the production process for a bit.WHERE DOES WIP FIT IN THE PRODUCTION PROCESS?Depending on the product being manufactured and the business processes and practices of the company, the production process may be simple and straightforward, or it may be complex and composed of more than a few stages or phases. At every stage of the production process, costs will be added, and these costs will be accumulated in the WIP.Once the raw materials and even the indirect materials have been placed into the production process, they cease to be raw materials and become WIP. However, since they have not yet fully gone t hrough the entire production process and remain unfinished, they still aren’t classified as Finished Goods.You can then say that the WIP is indicative of the flow of manufacturing costs from one production stage to the succeeding stages. Now how does WIP figure into the process of analyzing financial statements? We’ll get to that soon. But first, we have to establish what businesses should aim for with regards to WIP.WHAT SHOULD BUSINESSES AIM FOR WITH RESPECT TO WIP?As much as possible, retail and merchandising businesses want to have a reasonable balance in their Inventory accounts. Not too large, but not completely zero, either. This same goal applies to WIP, which directly relates to the production process of the company.Manufacturing companies are more concerned with keeping its production at optimal levels. Production management that aims to keep things at such optimal levels means that the firm should put effort in minimizing its WIP.Why is that? Shouldn’t you aim for a higher amount to appear in the Balance Sheet? Not necessarily, considering that the accounts and components have varying implications.The main reason why you should keep your WIP at minimal levels is to keep the associated costs low. You se e, WIP, or any inventory for that matter, requires storage and warehousing. While awaiting completion, they will take up floor space in your warehouse, and will also require the use of various utilities to “preserve” them until such time that they can be processed further for completion. Your warehouse will utilize electricity, and you may have to spend on manpower costs to maintain them and even keep them secure.What if you don’t store them and, instead, keep them in the assembly line? Well, that is even worse, because it means that you have WIP in queue, and it is holding up the flow of work in the production process. The likely effects are backlogs and slow production rates, which can result to bigger problems when you are unable to meet a high demand from customers.Further, this means that the cost is tied up in the inventory account. You won’t be able to invest those funds or use them for other business purposes while they are still tied up in WIP. If you have a high WI P, there is a large amount that you won’t be able to invest until they have been completed and sold.You’re going to understand this well when we go into analyzing the financial statements.WIP IN HORIZONTAL ANALYSISHorizontal analysis, which you may also know as trend analysis, involves comparing financial statement data over a series of reporting periods, with the intention to see the trend or pattern of financial information on operations of a business from period to period. The main concern is to note the increases or decreases, if any. The comparison may spark greater interest if there are obvious discrepancies or differences, prompting management and investors to look deeper into the operations, for the reason or cause of said differences.In the horizontal analysis of the Balance Sheet, the balances of the different accounts under the three categories â€" Assets, Liabilities and Stockholders’ (or Owners’, depending on the form of business) â€" are compared with that of t he balances of previous years to recognize trends and spot any irregularities.As we have already established earlier, WIP forms part of Inventories account, which is under the Current Asset heading in the Asset section. In some cases, the comparison will be made using the total figures of each period for Inventories, but it would be more accurate to compare the respective balances of the various components of the Inventories account.What can you tell if you employ horizontal analysis on WIP?An increase in the ending WIP inventory from period to period may indicatethat there is an increase in the demand for the company’s products, if Sales levels also show an upward trend;that the company is manufacturing more or faster than it can actually sell, if Sales levels are decreasing or remain relatively stable/constant; andthat the production process may be experiencing a slowdown and cannot complete products fast enough to meet deadlines, resulting to excess WIP inventory, if Sales leve ls show a downward trend.A decrease in the ending WIP inventory from period to period may indicatethat the company is not manufacturing enough products, or the production process is not fast enough to manufacture products, that will meet the demand; anda weakening in the demand for the company’s products, prompting management to revisit its production processes and marketing programs.WIP IN VERTICAL ANALYSISIf Horizontal Analysis involves the evaluation of a series of financial statements for more than one reporting period, Vertical Analysis focuses on the financial statement of a company for a single period. In this method, each line item of the financial statement is treated as a percentage of the whole.The purpose of this type of analysis is to determine the proportion of account balances. If it turns out that there is an abnormal disparity between the proportion of Current Assets and Non-Current Assets to the Total Assets, this is bound to prompt management to reassess how it utilizes its resources in its operations. You are likely to use this method when you’re comparing the financial data and performance of different companies, regardless of the difference in their sizes.For example, in the Balance Sheet, each line item is taken as a percentage of the Total Assets. Meanwhile, in the Income Statement, each expenditure and cost line item is taken as a percentage of the Total Sales.As an illustration, here’s an excerpt of the Inventories section of two different-sized companies in the same industry. Company ACOMPANY ACOMPANY BAmount (in USD)Amount (in USD)Raw Materials12,000 (4.3%)170,000 (9.1%)Work in Process26,000 (9.4%)240,000 (12.9%)Finished Goods11,000 (4.0%)260,000 (14.0%)Total Inventories49,000 (17.8%)670,000 (36.2%)Total Assets275,000 (100%)1,850,000 (100%)The above data, combined with results of analysis of the other line items and the various factors that may affect them, will give you more information on which company is performing better f inancially.This will provide a clearer and more accurate picture, rather than simply relying on the bottom figures (Total Assets, Total Sales, and Net Income).WIP IN FINANCIAL RATIO ANALYSISAlthough horizontal and vertical analysis methods are used often, there is no doubt that the most prefer to employ financial ratios in analyzing financial statement data. The preference is because these ratios easier and quicker to use, and they are applicable even when you are analyzing financial statement data over time, or among businesses within the same industry.Financial ratios are also more specific. If you want to know something about a company’s financial state, such as its liquidity or profitability, all you have to do is use the appropriate financial ratios.And yes, WIP also figures greatly when you use financial ratio analysis. Let’s go over some of the most salient points.Current RatioCurrent Ratio is a prime ratio used to measure a company’s liquidity, or its ability to quickl y convert its assets into cash when it is in the middle of a financial crisis, and still continue its operations.This ratio shows the relationship between your current assets and current liabilities. Do not forget that your WIP ending inventory balance is a component of your current assets. It is computed using the formula below. How it works:   Obviously, you’d want a high Current Ratio, such as 3:1 or 4:1, since this means you won’t have any trouble turning your current assets â€" even your WIP â€" into cash whenever you run into financial difficulties. This means you have more Accounts Receivables that you can collect on and Finished Goods Inventory that you can sell. You probably even have short-term marketable securities that you can quickly sell to raise some cash.Of course, this is not conclusive when it comes to inventories, which are not entirely liquid. The WIP, for example, cannot be sold immediately precisely because they are NOT yet completed and therefore they are NOT yet ready for sale. Unless, of course, the nature of the product allows it to be salable even when it is partially completed. For example, a manufacturer of electronics products may sell its partially completed units in its WIP to another company with similar manufacturing operations. That could work.That’s why you shouldn’ t take the Current Ratio at face value alone. You still have to dig deeper into the components. What if Inventories, particularly the generally-unsellable WIP, make up a very large part of Current Assets? Then it could mean that your company is not as liquid as you thought.Working CapitalWorking Capital serves as an indicator of your ability to meet your current obligations as they fall due. These current obligations include those that are usually incurred in the normal operations of the business, such as electricity bills and other utilities, salaries and wages, and payments on short-term loans.Working Capital     =     Current Assets â€" Current LiabilitiesHow it works: You’d definitely want to have a higher amount of working capital, since this means that you are in a better position to make your payments on time, as they fall due. With respect to WIP, Working Capital will tell you about the WIP Days, or the average number of days that you can afford to keep units or jobs i n progress before they are completed and delivered to customers.WIP Days     =     Total Current WIP Used / Total Production Cost x No. of DaysTo illustrate, let us say that, for the year, the total Production Costs add up to $3,000,000. Currently, the total WIP used amounts to $1,300,000, and you operate for 360 days in a year. By applying the formula above, the WIP Days is equal to 156 days.What does this mean? This means that units or jobs should be in progress for an average of 156 days. If you go beyond that, you might not be able to sell the finished goods because the customers looked elsewhere for another source. Therefore, you have to make sure the production process goes on smoothly, and that you are not taking more jobs or orders than you can take on.Inventory TurnoverInventory Turnover, or inventory turns, will show you how effective you are at managing your inventory levels. Take a look at the formula below. You might be wondering how WIP comes into play in this, since Inventory Turnover actually refers to the Finished Goods Inventory, and how it fares in comparison to your sales level during a specific period.Let me walk you through it. In the formula above, you have to get two figures. The Cost of Goods Sold (COGS) and the Average Inventories. The Average Inventories is easy enough, since you only have to take the average between the beginning and ending balances of the Finished Goods Inventory.It’s the COGS part that you have to pay closer attention to. COGS, by the way, is the equivalent of Cost of Sales in a retail business, referring to the cost of goods or products that were actually sold during the period.Finished Goods Inventory, beginning balanceXXXAdd: Cost of Goods ManufacturedXXXTotal Cost of Goods Available for SaleXXXDeduct: Finished Goods Inventory, ending balance(XXX)Cost of Goods Sold (COGS)XXXStill don’t see where WIP comes in? Be patient. In the computation, you h ave to have a separate computation to get your Cost of Goods Manufactured, which basically refers to the production costs that apply to the products that have been completed during the reporting period.WIP Inventory, beginning balanceXXXAdd:     Raw or Direct Materials usedXX     Direct Labor employed/usedXX     Allocated/Assigned OverheadXXTotal Manufacturing Costs IncurredXXXDeduct:                             WIP Inventory, ending balance(XXX)Cost of Goods ManufacturedXXXThere you go.How it works:   This ratio will tell you about your inventory management and sales performance. Generally, a high WIP used means a high Cost of Goods Manufactured, which will also increase your Cost of Goods Sold. Usually, this also means a high Inventory Turnover Ratio, which is preferred, since it may indicate strong sales performance. It may also be an indicator that you are not holding any excess inventory and incurring related inventory costs unnecessarily.If you take a look at the Balance Sheet and the Income Statement, there is no doubt that you will find more areas where WIP â€" be it the Inventory account or the WIP used or incurred during the period â€" will have an impact. In fact, it is safe to say that WIP has an effect on the net income or overall profitability of the company.WRAPPING IT UP…Through the analysis of financial statements, you will be able to see how important it is to also include the WIP in your inventory management and control policies and activities. After all, it is a critical component of the production process, and every movement will have an effect on your financial statements.