Investment ABCs - Inventory

Because there are many accounting terms used in the investment community that you should be familiar with as an investor, I am publishing a series of articles intended to highlight some important accounting issues and how they relate to the evaluation of stocks. This is the third article of the series.

One of my previous articles discussed working capital, how it is calculated, and its importance to investors. A key component of working capital is inventory. A simple examination of a company's inventory balance and the changes in the balance over time can often provide early indications of serious problems. As I mentioned before, being a successful investor often depends as much on staying away from bad investments as finding and investing in the good ones.

Most of you probably have at least a basic understanding of what inventory is. Basically, inventory generally refers to the assets that the company holds for sale to its customers. However, there are actually a few different types of inventory:

Supplies - include miscellaneous consumables such as stationary or cleaning products that are used by the corporation in the course of its everyday operations but which are not generally sold to customers.

Raw Materials - includes parts, components, sub-assemblies, or other items purchased from other manufacturers or producers that will be incorporated into the company's final product

Finished goods - includes all final products that are ready for sale to customers

Work in Progress - Raw materials that have been partially converted into finished goods by the corporation

Inventory can account for a substantial proportion of the total assets of many corporations, especially those in the retail sector. As a result, many companies invest an enormous amount of capital in building and maintaining sufficient inventories to meet the requirements of their customers. Given this investment and that fact that inventory is generally regarded as the least liquid of all short-term (current) assets, careful management of inventory is critical to the success of most companies.

Business managers must weigh the risks of holding too much inventory versus holding too little. If they hold too much, they might not be able to sell it all before the product becomes outdated or obsolete. They will also incur additional warehousing, inventory management, and insurance costs which will negatively impact profitability. On the other hand, if they don't stock enough, they might not be able to meet the sales demand for its customers and could jeopardize losing customers to competitors who can deliver more product.

General risks of holding too much inventory: - unnecessary use of capital that could be employed elsewhere - increased warehousing cost, including insurance - changes in prices (value), styles, or consumer acceptance

General risks of holding too little inventory: - can't meet sales demand; miss out on important sales opportunities - unable to deliver product on time to meet customer requirements

As private investors, it is difficult to examine all of the aspects of a company's inventory, but there are certainly a few tools that can be used to quickly examine a company's inventory for potential problems. The inventory turnover ratio can be used as an overall measure of the effectiveness of inventory control:

Inventory Turnover Ratio = (Cost of Goods Sold for the most recent quarter X 4) / Inventory at the end of the quarter*

* Many analysts prefer to use the average inventory for the latest quarter instead of the balance at the end of the quarter. To calculate an approximate average for a given quarter, add the inventory balance at the beginning of the quarter to the balance at the end of the quarter and divide the resulting number by 2.

Inventory turnover can also be expressed in days = 365 / Inventory Turnover Ratio

As in the examination of receivables turnover, the change in the inventory turnover ratio over time is more important than the actual ratio derived from the calculation. Inventory turnover depends greatly on the nature of the business being evaluated. For example, one would certainly expect that a company that sold fresh produce would have a much higher inventory turnover than a company that builds and sells jet aircraft. However, if you can obtain reliable industry averages, it can be useful to compare the ratio to other companies in the same sector to get a feel for the relative efficiency of a firm's inventory management. It is important to note that such analysis has significant limitations given that comparable companies may have differing accounting policies.

Any change in the inventory balance in excess of 15-20% over the course of a year should have a valid reason, such as a general increase in sales activity, the recent addition of a new product line, the completion of a major sale immediately prior to the current balance sheet date, or a recent acquisition.

An unusually low or declining inventory turnover ratio suggests one of the following: a). management is being very conservative to ensure that it always has enough stock on hand to meet customer demand - this could be important in industries which face unexpected surges in product demand b). the company is having a harder time selling its product than originally anticipated - demand for the product could be diminishing due to changes in customer preferences, new products introduced by a competitor, or a multitude of other reasons. If the situation continues to worsen, the company may face an impairment in the value of the inventory due to obsolescence. which in turn could result in write-offs that would negatively impact profits and investor confidence in the company. Worse yet, if the company's product is losing market share, its whole business could be in jeopardy if a competitor has developed a product that better suites the needs of the market.

An unusually high inventory turnover can also be a problem if the company is having to turn away potential sales due to its limited stock. This can be particularly true if customers are looking, as many are in today's economy, for suppliers who can provide a full suite of products, not just a few fast-moving items.

It only takes a few moments to calculate the inventory turnover ratio, yet it could save you from a disastrous investment. When considering new investment opportunities, take the time to calculate the ratio for the past several quarters and compare the trend and changes in the ratio. If you identify a concerning pattern, make sure you get appropriate answers from management before you put your hard earned money on the line.

Grant Robertson, B.B.A.

Disclaimer: The author is not a registered investment advisor. Accordingly, this article is presented for educational and information purposes only. Those seeking specific investment advice should consult a registered investment advisor. You are urged to consult your investment advisor before embarking on any new investment strategy as the strategies depicted in this article may not be suitable for all investors.