The Risks of Excessive Balance Sheet Inventory

manager analyzing a balance sheet
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For certain types of businesses, inventory on the balance sheet is among the important items you'll need to become familiar with because it can give you insights into what is happening with the core business in ways other analyses cannot.

A business assumes risks when it carries inventory. Some of the risks are inherent and unavoidable. However, there are some risks that can be planned for and are manageable. When you are assessing whether a business is worth investing in, industry and inventory size is an important comparison.

Some risks that are manageable and worth considering when comparing companies and industries are inventory obsolescence, spoilage, and shrinkage.

Some General Information

A balance sheet will not indicate for you the risks taken on by a large inventory. It will state how much inventory value a business has. The information you need to determine risks is generally carried in a company's annual reports, in the footnotes of the balance sheet or other areas.

For example, in their 2018 annual report, Target states,

"We believe the risk of inventory obsolescence is largely mitigated because our inventory typically turns in less than three months."

What this means for an investor is that they'll have to dig into company reports to find the information they are after.

Inventory Risk #1: Obsolesce

When too much inventory remains on the balance sheet, there is a risk of products becoming obsolete. This means that the company will either be unable to sell the inventory or must reduce the price of the inventory. To be an attractive purchase to consumers, the prices will need to be reduced substantially as there will be newer, more improved goods on the market. 

Take Nintendo, the Japanese gaming giant, for example. In the early 2000s, the company's then-newest video game system, the Game Cube, would someday be worth far less than the value at which Nintendo carried the inventory on its balance sheet. New gaming systems with upgraded hardware was later released, resulting in the older Game Cubes selling in discount stores or online auctions.

When inventory becomes obsolete, a company must reduce its value on the balance sheet by taking a write-down on the income statement (reporting a loss of inventory value).

If a company habitually writes down large amounts of inventory, it could indicate that management is unable to align production and procurement with a reasonable expectation of demand. At the very least, it should serve as a red flag, warranting further investigation.

Inventory Risk #2: Spoilage

Spoilage is precisely what it sounds like, occurring when a product actually goes bad and cannot be sold. This is a serious concern for companies that manufacture, assemble, and distribute perishable goods. 

For example, if a grocery store owner overstocks ice cream, and two months later, half of the ice cream has gone bad because shoppers chose another brand of ice cream or avoided the freezer section entirely, the grocer has no choice but to throw it out. Normal spoilage is accounted for in the cost of goods, where abnormal spoilage is charged as an expense incurred.

Inventory Risk #3: Shrinkage

When inventory is stolen, shoplifted, or embezzled, it is referred to as "shrinkage". The more inventory a firm has on the balance sheet, the greater the chances of being stolen. This is the reason that inventory-heavy companies with a lot of public access are so extraordinarily sophisticated at risk mitigation. 

To provide a real-world illustration, Target Corporation, one of the largest discount retailers in the United States, has what amounts to a very impressive forensic investigation unit. The unit is so good that it receives help requests from law enforcement agencies to assist in solving violent felonies or special circumstance crimes.

A good way to see how effectively management is dealing with the risk of inventory shrinkage is to compare a firm against other businesses in its same sector or industry. If you're examining a chain of drug stores and one has substantially higher losses from inventory shrinkage than everyone else in their field, it tells you that management may not be effectively mitigating their risk.

The Risks of Carrying Too Much Inventory

The inventory figure on the balance sheet presents an interesting, if not unique, problem. While an inventory increase is not necessarily bad and depends on the industry, it creates risks that can harm the business if not managed. If these risks come to fruition, they can manifest themselves in losses that reduce both returns on equity and returns on assets.