Inventory on the Balance Sheet

Investing Lesson 3 - Analyzing a Balance Sheet

Inventory on the Balance Sheet
When analyzing a balance sheet, pay careful attention to the inventory figures. What accounting method is used to track the inventory? How does inventory compare to competitors? Are there are significant changes in the relative percentage of assets made up by inventory over recent years?. PNC / DigitalVision / Getty Images

When looking at a company's current assets, you need to pay special attention to inventory. Inventory consists of merchandise a business owns but has not sold. It is classified as a current asset because investors assume that inventory can be sold in the near future, turning it into cash.  For certain types of businesses, inventory on the balance sheet is among the most important items you'll need to analyze because it can give you insight into what is happening with the core business in ways nothing else can.

To come up with a balance sheet estimate of inventory, companies must use different rules and methodology to account for the goods.  For example, there is the FIFO inventory method, which is the "first in, first out" method.  There is LIFO inventory method, which is the "last in, first out" method.  There is "percentage of completion" inventory method, which is particularly useful for the pro-rated recognition of contractually guaranteed sales when the company you are studying is a manufacturer that has to physically produce the goods it must deliver.  There is the ​weighted average inventory method.  There is the specific identification inventory method.  How these influence both the balance sheet figures and the income statement, especially during times of inflation, is something you should understand if you hope to do well as an investor or manager.

Carrying Too Much Inventory on the Balance Sheet Can Be a Major Risk

The inventory figure on the balance sheet presents an interesting, if not unique, problem.

 When inventory piles up, it faces three major risks that can harm the business.  If these risks come to fruition, they can manifest themselves in losses that reduce both the return on equity and return on assets.

The First Inventory Risk Is the Risk of Obsolesce

The first inventory risk is the risk of obsolesce; the risk of a product becoming obsolete.

 This means that the company will either be unable to sell the inventory or must reduce the price of the inventory substantially to sell it as there are now more attractive goods on the market.  When I first wrote this investing lesson back in 2001-2002, I used the example of Nintendo, the Japanese gaming giant.  I talked about how the company's then-newest video game system, the Game Cube, would some day be worth far less than the value at which Nintendo carried the inventory on its balance sheet.  The reasons are not hard to understand.  New systems would be released (and they have been).  People could buy Game Cubes at second-hand stores or online auctions (they can and do).  

When inventory becomes obsolete, a company must reduce its value on the balance sheet by taking a write-down on the income statement.  If a company habitually writes down large amounts of inventory, it could indicate that management is incompetent and highly inefficient, unable to align production and procurement with a reasonable expectation of demand.  At the very least, it should serve as a major red flag, warranting further investigation.

The Second Inventory Risk Is the Risk of Spoilage

Another inventory risk is spoilage.

Spoilage is precisely what is sounds like, occurring when a product actually goes bad. 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 it has not been purchased, the grocer has no choice but to throw it out. The estimated value of the spoiled ice cream must be taken off the grocery store's balance sheet.  It's lost money.

The Third Inventory Risk is Shrinkage

Inventory shrinkage refers to inventory that is stolen, shoplifted, and embezzled.  The more inventory a firm has on the balance sheet, the greater the chance it is going to be stolen.  This is the reason that inventory-heavy companies with a lot of public access are so extraordinarily sophisticated at risk mitigation.

 To provide one real-world illustration, Target Corporation, the second largest discount retailer in the United States, has what amounts to one of the most impressive forensic investigation units anywhere on the planet to the point that it is now the stuff of corporate legend.  It is so good that, far from its original intended purpose of reducing inventory shrinkage, it has helped law enforcement solve murders, rapes, arsons, and other 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 probably needs to be replaced and there is a potential to make a lot more money as the core earnings could be higher than their present level.  (This might seem paradoxical but there are times when investing in bad businesses becomes particularly profitable.)