# Working Capital: inventory

Inventory

Inventories are either a very complex topic or a very simple one.  I’m taking the simple route here.

One ratio:  inventory/sales (or sales/inventory)

There’s only one ratio that securities analysts are interested in:  inventory/sales. As with other working capital items, one could also calculate inventories/cost of goods, but I don’t think that using this less common ration gets materially different results.

What the ratio means

The significance of the ratio is what one would expect–it’s bad if the ratio of inventory/sales starts to go up vs. historical experience.

Two cases

In looking at inventories, it’s important to distinguish two cases:  manufacturing companies, which create products or services, and distribution companies, which add their value by selecting among products of manufacturers and making them available either to other distributors or to end-user customers.

1. Manufacturing companies. For a manufacturer, inventory is classified into three categories:

–raw materials,

–work in process, and

–finished goods.

You’ll probably be able to get additional information from examining the percentage of total inventory contained in each category, but normally looking at the overall inventory total will be good enough.

A rise in the inventory/sales ratio usually represents an unanticipated slackening in demand for products contained in the finished goods inventory.  The falloff can be the result of a general economic slowdown, the emergence of new competition, or something wrong with the product itself.

(Note: while an unintended rise in inventories is a bad thing, a 15% rise in the dollar amount of finished goods doesn’t mean there are 20% more items in the company’s warehouses.  For example, assume the company has factory costs of \$1 million a quarter that it allocates over full-capacity production of 1 million units.  That amounts to \$1 per unit.  If the variable costs for each unit are \$1, then the total cost per unit will be \$2.  If nothing is sold during the quarter, the total dollar amount added to inventory will be \$2 million.

If the beginning inventory is 5 million units and \$10 million, then the ending inventory is 6 million units and \$12 million.

Now suppose instead that the company responds to order cancellations by cutting current-quarter production in half.  That means it makes 500,000 items at a variable cost of \$1 each.  It allocates \$1 million of factory costs of those items at a rate of \$2 each.  So total cost per unit is \$ 3.  Ending inventory is 5.5 million units and \$11.5 million in value.  In this case, the dollar value of inventory has gone up by 15%, but total units are only up by 10%.)

2. Distribution companies (think: Amazon, Advance Auto Parts or a supermarket).  Distributors are typically low-margin, high inventory turnover businesses.  They may have considerable value imbedded in their brand names, the know-how that produces their logistics computer systems and their physical store locations.  But these positive attributes do not often manifest themselves in high operating margins.  As a result, because they do not have the high margins of companies with significant legally-protected intellectual property, some growth investors tend to underestimate their earnings expansion potential.

Distributors’ claim to fame rests in their ability to turn inventories quickly.  For this reason, analysts usually place a lot of their analytic efforts on inventories, which they talk about in terms of “turns,” that is, annual sales divided by average (or some other measure to smooth out seasonal variations) inventories.

Since distribution companies usually don’t have exclusive rights to sell unique products, the sales/inventory ratio–how many times it can “turn” inventories in a year–is a good standard of comparison across competitor distribution companies, as well as for comparing a firm with its own history.

For a strong distribution company, sales should rise faster than inventory.  Therefore, inventory turns should rise over time.

Any deterioration of the pattern, either a flattering out of turns or a decrease in turns, is a cause for concern.  On the other hand, an increase on turns, or even better, an acceleration of turns, is a very bullish sign.