Analyzing a company’s inventories and receivables is a reliable means of helping to determine whether it is a good investment play or not. Companies stay efficient and competitive by keeping inventory levels down and speeding up collection of what they are owed. In this article, we’ll take you through the process step by step.

As an investor, you want to know if a company has too much money tied up in its inventory. Companies have limited funds available to invest in inventory - they can’t stock a lifetime supply of every item. To generate the cash to pay bills and return a profit, they must sell the merchandise they have purchased from suppliers. Inventory turnover measures how quickly the company is moving merchandise through the warehouse to customers.

Let’s look at U.S. retail giant Wal-Mart, known for its super-efficient operations and state-of-the-art supply chain system which keeps inventories at a bare minimum. In fiscal 2003, inventory sat on its shelves for an average 45 days. Like most companies, Wal-Mart doesn’t provide inventory turnover numbers to investors, but they can be flushed out using data from Wal-Mart’s financial statements.

To get the necessary data, find its ‘Consolidated Statements of Income’ on its website (see http://investor.walmartstores.com and look for the 2003 Annual Report) and locate cost of goods sold (COGS), or “cost of sales” found just below the top-line sales (revenue). For the 2003 fiscal year, Wal-Mart's COGS totaled US$191.8 billion.

Then look at the ‘Consolidated Balance Sheet’ (the next page after ‘Statements of Income’). Under assets, you will find the inventory figure. For 2003, Wal-Mart's inventory was $25 billion, and in 2002, it was $22.7 billion. Average the two numbers ($25bn + $22.7bn / 2 = $23.9bn), then divide that inventory average for 2003, $23.9 billion, into the average cost of goods sold in 2003. You will arrive at the annual turnover ratio 8.0. Now, divide the number of days in the year, 365, by the annual turnover ratio, 8.0, and that gives you 45.3. That means it takes Wal-Mart just over 45 days, or about a month and a half, to cycle through its inventory. This number of inventory days is also known as the “days-to-sell” figure.

Broadly speaking, the smaller number of days, the more efficient a company - inventory is held for less time and less money is tied up in inventory. Instead, money is freed up for things like research and development, marketing or even share buybacks and dividend payments. If the number of days is high, that could mean that sales are poor and inventories are piling up in warehouses.

But remember, it’s not enough to know the number at any specific time. Investors need to know if the days-to-sell inventory figure is getting better or worse over several periods. To get a decent sense of the trend, calculate at least two years worth of quarterly inventory sales numbers. You will see that Wal-Mart’s inventory days gradually declined from 2001 to 2003.

If you do spot an obvious trend in the numbers, it’s worthwhile asking ‘why?’ Investors would be pleased if the number of inventory days were falling as a result of greater efficiencies gained through tighter inventory controls. On the other hand, products might be moving off the shelf more quickly simply because the company is cutting its prices.  

To get an answer, flip to the ‘Income Statement’ and look at Wal-Mart’s gross margin (top-line revenue, or net sales, minus cost of sales).

Check to see whether gross margins as a percentage of revenue/net sales are on an upward or downward trajectory. Gross margins which are consistent or on-the-rise offer an encouraging sign of improved efficiencies. Shrinking margins, on the other hand, suggest the company is resorting to price cuts to boost sales. Looking back at the numbers, you will find that Wal-Mart’s gross margins, as expressed as a percentage of net sales, bumped up 1% from 21.0% in 2002 to 22.1% in 2003 (gross margin = net sales - COGS / net sales).

If inventory days are increasing, that’s not necessarily a bad thing. Companies normally let inventories build up when they are introducing a new product in the market or ahead of a busy sales period. However, if you don’t foresee an obvious pick up in demand coming, the increase could mean that unsold goods will simply collecting dust in the stockroom.

Accounts receivable is the money that is currently owed to a company by its customers. Analyzing the speed at which a company collects what it’s owed can tell you a lot about its financial efficiency.

If a company's collection period is growing longer, it could mean problems ahead. The company may be letting customers stretch their credit in order to recognize greater top-line sales and that can spell trouble later on especially if customers face a cash crunch. Getting money right away is preferable to waiting for it - especially since some of what is owed may never get paid. The quicker a company gets its customers to make payments, the sooner it has cash to pay for salaries, merchandise and equipment, loans and, best of all, dividends and growth opportunities.

So, investors want to determine how many days, on average, the company takes to collect its accounts receivable. Here is the formula:

Receivables Days = 365 Days / (Revenues/Average Receivables)

On the top of the ‘Income Statement’, find revenues; on the ‘Balance Sheet’ under current assets, you will find accounts receivable. Wal-Mart generated $244.5 billion in net sales in 2003. At the end of 2003, its accounts receivable stood at $2.11 billion, and in 2002, it was $2 billion, yielding an average accounts receivable figure of about $2.0 billion.

Dividing revenue by average receivables gives a receivables turnover ratio of 122. This shows how many times the company turned over its receivables in the annual period. Three hundred and sixty-five days of the year divided by the receivables turnover ratio of 122 gives a receivables turnover rate of three days. On average it took about three days for Wal-Mart to receive payment for the goods it sold.

It’s good news when you see a shortening of both inventory days and the collection period. Still, that’s not enough to full understand how a company is running. To gauge real efficiency, you need to see how the company stacks up against other players in the industry.

Let’s see how Wal-Mart compared in 2003 with Target Stores, another large, publicly-listed retail chain. Dramatic differences can be seen. While Wal-Mart on average turned over its inventory every 45 days during that period, Target’s inventory turnover took nearly 60 days. Wal-Mart collected payments in just three days. Meanwhile Target, which relied heavily on slow-to-collect credit card revenues, required almost 40 days to get its money. As Wal-Mart shows, using competitors as a benchmark can enhance investors’ sense of a company’s real efficiency.

Still, comparative numbers can be deceiving if investors don’t do enough research. Just because one firm’s numbers are lower than a rival’s doesn’t always translate to more efficient performance. Business models and product mix need to be taken into account. Inventory cycles differ from industry to industry.

Keep in mind that these efficiency measures apply largely to companies that make or sell goods. Software companies, firms that sell intellectual property as well as many service companies do not carry inventory as part of their day-to-day business, so the inventory days metric is of little value when analyzing these kinds of companies. However, you can certainly use the days receivables formula to examine how efficiently they collect what’s owed.

For further reading on related subjects, see The Bottom Line on Margins, Working Capital Works, as well as other articles in our Fundamental Analysis Archive.

Conclusion

Getting behind the scenes at a company means more than simply knowing its earnings per share (see Types of EPS and How To Evaluate The "Quality" Of EPS and our tutorial Understanding The P/E Ratio). Finding out where a firm’s cash is tied up in inventories and receivables can help shed light on its how efficiently it is being managed. Of course, it takes time and effort to extract the information from company financial statements. But doing the analysis will certainly help you find which companies are worthy of investment.