For certain types of businesses, knowing how much inventory is on the balance sheet can give a vital look at the health of the company. This is because a firm takes on risk when it carries inventory. Some of the risks are built-in and certain, while there are some risks that can be planned for and managed. A risk that is worth thinking about when looking at companies and sectors to invest in is inventory that is dated or spoiled. You also want to see how much inventory the firm loses through theft or other loss.
- A balance sheet will not outright say what risks come with a large inventory, but it will state how much inventory value a firm has.
- Having too much inventory of a product is a risk because that item may become obsolete. In turn, the firm may not be able to sell it.
- Spoilage occurs when a product goes bad and can't be sold. This is a valid concern for firms that make or distribute goods that have a shelf life.
- Shrinkage occurs when inventory is stolen or taken. The more inventory a firm has on the balance sheet, the greater the chance of it being stolen.
A balance sheet will not show the risks that come with a large inventory. Instead, it will only state how much inventory value a business has. The information you need to find the risks can be found in, among other things, a firm's annual report 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 of a product on the balance sheet risks making that product dated. In turn, the company may be unable to sell the item or items. To make an outdated product a good buy for buyers, its price would need to go down by a lot since there may be newer and better goods on the market.
Take, for instance, Nintendo. In the early 2000s, this company in Japan 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. Then, the product had to be sold in discount stores or online auctions.
When inventory becomes obsolete, a firm must reduce its value on the balance sheet by taking a write-down on the income statement. This means they report a loss of inventory value. If a company writes down large amounts of inventory time and time again, it may be due to the fact that people in charge are unable to align product and getting the product made with a firm expectation of demand. At the very least, it should serve as a red flag and warrant a deeper look.
Inventory Risk #2: Spoilage
Spoilage occurs when a product goes bad and cannot be sold. This is a big concern for companies that make, assemble, and distribute perishable goods.
For instance, if a store owner has too much ice cream in stock, and half of the ice cream goes bad after two months because shoppers chose another brand of ice cream or didn't buy any, the grocer has no choice but to throw out the overstock. Normal spoilage is accounted for in the cost of goods, but high spoilage is charged as an expense.
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 companies that have a lot of stock and public access to that stock have become very good at risk mitigation.
For instance, Target, one of the largest discount stores in the U.S., has a very good forensic investigation unit. In fact, this unit receives help requests from law enforcement for help in solving violent or special circumstance crimes.
To see how well a company deals with the risk of theft, an investor can try looking at it against other businesses in the same sector or industry. If you look at a chain of drug stores and find that one has much higher losses from shrinkage than any other stores in its field, it should show or at least suggest to you that people in charge may not know how to lower risk very well.
Inventory on the balance sheet presents a unique problem. While an increase in inventory is not always bad and depends on the industry, it creates risks that can harm the business if not properly managed. If these risks come to pass, they can cause losses that reduce both returns on equity and returns on assets.