The Risks of Excessive Balance Sheet Inventory
For certain types of businesses, inventory on the balance sheet is an important item you will need to become familiar with, as it can help illuminate 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, while there are some risks that can be planned for and are manageable. Some risks that are worth considering when comparing companies and industries are inventory obsolescence, spoilage, and shrinkage.
A balance sheet will not explicitly indicate the risks associated with large inventory. Instead, it will only state how much inventory value a business has. The information you need to determine risks is generally found in, among other things, a company's annual reports and the footnotes of balance sheets.
For example, Target states in its 2018 annual report:
"We believe the risk of inventory obsolescence is largely mitigated because our inventory typically turns in less than three months."
Investors would need to look through such reports to find the information sought.
Inventory Risk #1: Obsolescence
Having too much inventory of a product on the balance sheet risks making that product obsolete. In turn, the company may be unable to sell the inventory. To make the product an attractive purchase to consumers, its price would need to be reduced substantially, especially since there may be newer, improved goods on the market.
Take, for example, Nintendo. In the early 2000s, this Japanese company had a video game system called GameCube. This product has become worth far less than the value at which Nintendo carried the inventory on its balance sheet at that time. New gaming systems with upgraded hardware entered the market over time, and the product had to be sold 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 (i.e., reporting a loss of inventory value). If a company habitually writes down large amounts of inventory, it may be due to the fact that management is unable to align product and procurement with a reasonable expectation of demand. At the very least, it should serve as a red flag and warrant further investigation.
Inventory Risk #2: Spoilage
Spoilage occurs 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 half of the ice cream goes bad after two months because shoppers chose another brand of ice cream or avoided the freezer section entirely, the grocer has no choice but to throw out the overstock. Normal spoilage is accounted for in the cost of goods, whereas 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 chance of it being stolen. This is why inventory-heavy companies with a lot of public access are extraordinarily sophisticated at risk mitigation.
For example, Target, one of the largest discount retailers in the United States, has what is a very impressive forensic investigation unit. In fact, this unit receives help requests from law enforcement agencies for assistance in solving violent felonies or special circumstance crimes.
To see how effectively a company deals with the risk of shrinkage, an investor can try comparing it against other businesses in the same sector or industry. If you examine a chain of drug stores and find that one has substantially higher losses from shrinkage than any other stores in its field, it should indicate or at least suggest to you that management may not be effectively mitigating risk.
Inventory on the balance sheet presents an interesting, if not unique, problem. While an increase in inventory is not necessarily bad and depends on the industry, it creates risks that can harm the business if not properly managed. If these risks come to fruition, they can manifest themselves in losses that reduce both returns on equity and returns on assets.