A:

In accounting, inventory represents a company's raw materials, work in progress and finished products. Financial professionals use a wide variety of quantitative and qualitative techniques to understand inventory in their investing analyses. Quantitative techniques involve performing ratio analysis of the inventory by calculating ratios using financial statements. Qualitative analysis includes inspecting notes to financial statements to check inventory valuation methodology and its consistency, researching inventory valuation methods used by competitors and comparing them to the method used by the company.

In finance, ratio analysis is done by calculating ratios using historical inventory balances. The purpose of this analysis is to detect a company's problems with inventory management, such as difficulty selling inventory, inventory build-up and obsolescence. The most common inventory ratios are days inventory outstanding, inventory turnover and inventory to sales ratio.

The days inventory outstanding ratio is calculated as inventory divided by cost of goods sold (COGS) times 365. This ratio measures the average number of days a company holds inventory before selling it. This ratio widely varies across industries and is most helpful when compared against a company's peers. If the ratio increases over time and is much higher compared to its peers, this can be a red flag that the company is struggling to clear its inventory. Holding unsold inventory is costly, because money is tied up in an idle resource with no income until the inventory is sold. It is costly to store inventory, especially when it requires special handling. Also, certain inventory gets obsolete and may require selling at a significant discount just to get rid of it.

Inventory turnover is calculated as the ratio of COGS to average inventory. Sometimes revenues are substituted for COGS and average inventory balance is used. Inventory turnover is especially important for companies that carry physical inventory and indicates how many times inventory balance is sold during the year. Similarly to the days inventory outstanding ratio, inventory turnover should be compared with company's peers due to differences across industries. A low and declining turnover is a negative factor; products tend to deteriorate and lose their value over time.

Inventory to sales ratio is calculated as the ratio of inventory to revenue. Some analysts use an average inventory balance. An increase in this ratio can indicate a company's investment in inventory is growing quicker than its sales or sales are decreasing. On the other hand, if this ratio decreases, it can mean that a company's investment in inventory is decreasing in relation to revenues or revenues are growing. The inventory to sales ratio provides a big picture on the balance sheet and can indicate whether a more thorough analysis of inventory is needed.

In addition to ratio analysis, reading notes to financial statements is helpful in inventory analysis. Because the U.S. generally accepted accounting principles (GAAP) allow different valuation methods for inventory (LIFO, FIFO and average cost), a company's management can use this discretion to manipulate its earnings. Look for any changes in accounting policies related to inventory. Frequent and unjustified changes to inventory valuation methods can indicate earnings management. Also, comparing a company's inventory valuation methodology with that of its peers can provide a common sense check on whether the company's management is being aggressive with inventory valuation. Finally, look for any inventory charges, as they can pinpoint inventory obsolescence problems.

RELATED FAQS
  1. How do you calculate inventory turnover?

    Inventory turnover measures how many times inventory has sold during a period and provides insight into a company's inventory ... Read Answer >>
  2. What does a high inventory turnover tell investors about a company?

    Inventory turnover is an important metric for evaluating how efficiently a firm turns its inventory into sales. Read Answer >>
  3. What are the generally accepted accounting principles for inventory reserves?

    As with most matters related to generally accepted accounting principles (GAAP), accountants assigned with the task of applying ... Read Answer >>
  4. Which industries tend to have the most inventory turnover?

    Understand what inventory turnover measures and why it is good to have high inventory turnover. Learn what industries tend ... Read Answer >>
  5. How can an investor determine the efficiency of a company's working capital management?

    Learn how working capital is vital to a company’s survival. Also learn key metrics investors use to assess how efficiently ... Read Answer >>
  6. What do efficiency ratios measure?

    Learn about efficiency ratios, what they measure, how to calculate commonly used efficiency ratios and how to interpret these ... Read Answer >>
Related Articles
  1. Investing

    How to Analyze a Company's Inventory

    Discover how to analyze a company's inventory by understanding different types of inventory and doing a quantitative and qualitative assessment of inventory.
  2. Investing

    How to Calculate Average Inventory

    Average inventory is the median value of an inventory at a specific time period.
  3. Investing

    Measuring Company Efficiency To Maximize Profits

    Efficiency ratios can provide indications of profitability, shows how efficiently a company is being managed, utilizes its assets and handles liabilities.
  4. Investing

    Key Financial Ratios for Retail Companies

    Using the following liquidity, profitability and debt ratios, an investor can gather deeper knowledge of a retail company's short-term and long-term outlook.
  5. Investing

    Dynamic Current Ratio: What It Is And How To Use It

    Learn why this ratio may be a good alternative to the current, cash and quick ratios.
  6. Investing

    Why It Is Important to Follow Crude Oil Inventories

    Discover what oil inventories are, how they are communicated and what important insights they provide into the state of the oil market.
  7. Investing

    Liquidity Measurement Ratios

    Learn about the current ratio, quick ratio, cash ratio and cash conversion cycle.
  8. Investing

    Key Financial Ratios to Analyze The Automotive Industry

    Learn about the most critically important financial ratios investors and market analysts utilize to evaluate companies in the automotive industry.
  9. Investing

    Uncovering Oil And Gas Futures

    Find out how to stay on top of data reports that could cause volatility in oil and gas markets.
RELATED TERMS
  1. Inventory Turnover

    Inventory turnover is a ratio showing how many times a company ...
  2. Carrying Cost Of Inventory

    Carrying cost of inventory, or carry cost, often refers to a ...
  3. Inventory

    Inventory is the term for merchandise or raw materials on hand.
  4. Business Inventories

    Business inventories is an economic figure that tracks the dollar ...
  5. Obsolete Inventory

    Obsolete inventory is a term that refers to inventory that is ...
  6. Holding Costs

    Holding costs are a major component of supply chain management ...
Trading Center