Understanding inventory – what is it and why is it important?

From an accounting perspective, inventory appears on the company’s balance sheet as a current asset. It’s something the company should be able to sell within its normal business cycle (usually a year or less). Inventory is basically a mix of the following:

  • Raw materials – what is needed to make the product, if the company produces its own stock
  • Work in progress – goods in the process of being manufactured, but not yet ready for sale
  • Finished goods – finished items on hold and ready to be sold

2 useful inventory analysis tools

It’s all well and good to know where to find the inventory on the financial statements. But when you’re considering investing in a business, it’s important to have a few analytical tools up your sleeve to help you draw conclusions.

It’s worth a quick reminder that ratios are a great tool for comparing companies in the same industry or for observing how a company has changed over time. However, ratios and numbers taken in isolation are not as useful.

One of the most common ratios that analysts like to use is inventory turnover. The good news is that it’s fairly easy to calculate and only requires a few bits of information that you can extract from a company report.

Inventory turnover = cost of goods sold / average inventory

The cost of goods sold is an income statement item, it is subtracted from revenue to arrive at gross profit. The average inventory can be found on the balance sheet, just take the average of the inventory figure from year to year.

A high or increasing inventory turnover rate could suggest that inventory is well managed. Going back to the equation, a high or rising ratio means that the cost of goods sold is a higher number compared to the average inventory – suggesting that goods are being sold to customers rather than sitting in storage.

Of course, there are other interpretations depending on what’s going on with the broader business, so it’s always helpful to dig a little deeper into the context.

The inventory turnover rate can then be pushed a little further.

Days of stock on hand (DOH) = 365 / stock turnover

The DOH gives analysts a tangible number of the number of days it takes a company to sell through inventory. In this case, a low number could suggest that the company manages its inventory better.

Why is it important?

Let’s put these concepts to use with some real-life examples – starting with the world’s largest retailer, Walmart.

Inventory Management – ​​Walmart

Scroll to see the full table.

Source: Walmart Annual Reports, 2018-2022.

In the chart, you can see inventory levels increasing as inventory turnover decreases. Digging a little deeper, Walmart spent heavily on building inventory in late 2021 and early 2022. But the drop in inventory turns suggests the group has struggled to sell on that increased inventory at course of the year.

When businesses struggle to sell inventory, the dreaded discount can be on the cards. And in the case of Walmart, that’s exactly what’s happening. Greater economic uncertainty means spending on general merchandise and clothing has been kept under control this year. This left Walmart in the position of having to offer discounts to keep inventory moving.

The downside of discounting is its effect on margins. Underselling reduces the amount of profit made on each sale, which ultimately hurts the bottom line. A juggernaut like Walmart should be able to sustain some level of discount, but others might not be as isolated.

Let’s turn our attention to a booming fast fashion retailer, Boohoo. The dynamic here is a little different. In fast fashion, if stock doesn’t move quickly, it can quickly become obsolete.

Inventory Management – ​​Boohoo

Scroll to see the full table.

Source: Refinitiv Eikon 30.08.22 (*2023 figures based on analyst consensus)

Boohoo has made a serious effort to increase inventory levels this year, to expand to scale and capitalize on increased demand for its products. Unfortunately, general conditions have changed drastically, growth has slowed and inventory turnover has not been able to keep pace.

This is not an immediate cause for concern, but it could signal short-term inventory issues. Worse would be writedowns.

Depreciations occur when the net realizable value (a fancy way of saying the current selling price minus selling costs) is less than the value the company has on its balance sheet. This is because the current value of the inventory has dropped significantly since the time it was purchased. If this happens, the balance sheet value of the inventory is reduced and a charge goes through the income statement, reducing the company’s potential profits.

Beyond Retail

Retail is not the only industry where inventory management needs to be watched closely. Pharmaceutical giant Moderna reported just under $700 million in inventory write-downs in the first half of the year. This is equivalent to 6.5% of the total turnover for the same period, which is not negligible.

The writedowns were primarily the result of Moderna’s Covid-19 vaccine, which has a limited shelf life. The vaccine should be stored at temperatures between 36 and 46 degrees Fahrenheit and expires after 30 days. A mismatch between supply and demand meant that vaccine deliveries were not as large as expected, leaving unused doses on the shelves.

It’s not just Moderna, though. Another pharmaceutical giant, Pfizer, had a similar problem and had to write down $450 million in inventory in the second quarter. Again, this was related to Covid-19 products that had exceeded or were expected to exceed their shelf life.

Details of writedowns, their values ​​and why they occurred, will be available in a company’s financial results.

How important is inventory?

As inflation soars and a cost of living crisis begins to set in, it’s more important than ever to pay close attention to inventory levels.

It would not be surprising to see the discounts become more significant, and even the write-downs if recession fears arise.

Stock analysis could help shed light on which ones pose the most inventory risk and should be part of the decision process to invest or not.

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This article is not personal advice. If you are unsure whether an investment is right for you, seek advice. All investments can go down or up in value, and you could get back less than you invest.

Investing in individual companies is not good for everyone – it is a higher risk than investing in funds because your investment depends on the fate of that company. If a company goes bankrupt, you risk losing your entire investment. You should make sure you understand the companies you are investing in, their specific risks and ensure that any stocks you own are held as part of a diversified portfolio.

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