How to Analyze a Company's Inventory

Important to facility operations, inventory represents products a company possesses on its premises or goods consigned to third parties. Inventory plays an important role in the smooth functioning of a company's business since it acts as a buffer between the production and completion of customers' orders. Investors can find data on inventory in public filings of a company on its investor relations website or through the Securities and Exchange Commission (SEC) website.

While a company's balance sheet contains one line that shows end-of-period inventory balances, footnotes to financial statements show more details on inventory. These details typically include a description of how a company accounts for its inventory and detailed balances for different subcategories within an inventory account.

Types of Inventory

Inventory represents a current asset since a company typically intends to sell its finished goods within a short amount of time, typically a year. Inventory has to be physically counted or measured before it can be put on a balance sheet. Companies typically maintain sophisticated inventory management systems capable of tracking real-time inventory levels. Inventory is accounted for using one of three methods: first-in-first-out (FIFO) costing, last-in-first-out (LIFO) costing, or weighted-average costing.

An inventory account typically consists of four separate categories: raw materials, work in process, finished goods, and merchandise. Raw materials represent various materials a company purchases for its production process. These materials must undergo significant work before a company can transform them into finished goods ready for sale. Work in process represents raw materials in the process of being transformed into a finished product. Finished goods are completed products readily available for sale to a company's customers. Merchandise represents finished goods a company buys from a supplier for future resale.

Financial Ratios

To analyze inventory, financial professionals typically use various financial ratios to judge whether a company has any issues with producing and promptly selling its inventory. Financial ratios can also raise potential red flags about accounting fraud or obsolescence. Investors and analysts typically look at a company's inventory ratios over time and make comparisons among peers within the same industry.

Days sales of inventory (DSI) is a popular method of evaluating the average time it takes for a company to transform its inventory into revenues. DSI is calculated by taking the average annual inventory, dividing it by the cost of goods sold (COGS) for the same period, and multiplying the result by 365. The smaller the DSI, the more efficiently a company runs its business by quickly monetizing its inventory. DSI can vary for the same company over time for different reasons, such as inefficient use of inventory, outsourced production, and stuffing warehouses in anticipation for a higher number of orders in the next accounting period. DSI also varies from industry to industry. An aerospace company typically has very long conversion cycles in its production process, and its DSI can be more than 200 days. A retail company, on the other hand, can sell its items rather quickly, and its DSI is typically under 50 days.

The inventory turnover lets analysts evaluate the speed at which inventory is being utilized over a specific period of time, and it is calculated by dividing the ending inventory balance by the annual cost of goods sold. In case the ending inventory balance deviates significantly from the norm, the average annual balance can be used instead. Using the inventory turnover ratio, an analyst can assess if a company has excessive inventory levels on hand when compared to its sales level. The inventory turnover can fluctuate because of low sales or poor inventory management skills. The inventory turnover ratio varies from industry to industry.

Qualitative Analysis of Inventory

There are other methods used to analyze a company's inventory. If a company frequently switches its method of inventory accounting without reasonable justification, its management is likely trying to paint a brighter picture of its business than what is true. The SEC requires public companies to disclose LIFO reserve that can make inventories under LIFO costing comparable to FIFO costing.

Frequent inventory write-offs can indicate a company's issues with selling its finished goods or inventory obsolescence. This can also raise red flags with a company's ability to stay competitive and manufacture products that appeal to consumers going forward.

Article Sources
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  1. Securities and Exchange Commission. "Beginners' Guide to Financial Statements."

  2. New York University Stern School of Business. "Inventory Valuation Methods."

  3. Accounting for Management. "Types/Classification of Inventory."

  4. American Productivity & Quality Center. "Inventory Days of Supply."

  5. Cornell Law School Legal Information Institute. "17 CFR § 210.5-02 - Balance Sheets."

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