Inventory is one of the largest and most important assets a manufacturing business possesses, and the turnover of inventory is one of the principal sources of revenue generation for a company.
Inventory decisions directly affect the value of cost of goods sold and consequently play a pivotal role in determining the reported earnings of a company. As a result, a thorough analysis of inventory valuation and related accounts can provide a basis for assessing the financial position of a firm.
The management of inventory and how it can provide insight into firm performance is topic of interest to shareholders, investors, business owners, and the general public. Firm profits can sometimes be deceptive and costs can be hidden in inventories.
Through examination of inventory practices and how they differ over time, it should become easier to judge the stability of a firm and the likelihood that it will perform well in future periods. For example, during an economic downturn, if a firm has high levels of inventory as a result of below average sales, management may write off or write down inventory so that cost of sales for the old inventories will be less in subsequent periods.
In this case, firms are incurring a loss in the current period so that their balance sheets will reflect the true values of their inventories, and in turn they will recognize less costs them less in the future when they sell older goods which are diminished in value.
Simply put, understanding management preferences and behaviors with respect to inventories allows shareholders and other investors to make decisions based on their expectations of firm performance in response to external factors, such as economic conditions.
Moreover, firms may have different incentives that influence their inventory decisions. Management may benefit from reaching a certain earnings estimate, or may have pressure to show steady growth in income and consistent inventory levels.
Understanding these incentives and the consequent decisions that are made also help to indicate how we should expect firms to respond to various economic and external pressures. This analysis also serves to show which firms are better positioned to deal with such pressures; firms with high inventory turnover and a low likelihood of overvalued inventories on the balance sheet, or firms with low inventory turnover that are likely to write-down inventories during recessions.
Stability is an important factor to consider when it comes to deciding on an investment strategy, and such trend analysis may reveal the types of firms that tend to be more stable. If it is found that a firm with high inventory turnover may be more stable and likely to show steady growth in the future, an investor may choose an investment strategy which relies on such firms.
Indeed, understanding inventory practices and trends is a valuable skill that helps to indicate the stability and growth prospects of firms, industries, and the economy as a whole.
Source: University of Connecticut
Author: Rishi Gokarn