How is inventory analyzed on the balance sheet?

In accounting, inventory represents the raw materials, work in progress, and finished products of a business. Financial professionals use a wide variety of quantitative and qualitative techniques to understand inventory in their investment analysis. Quantitative techniques involve conducting an inventory ratio analysis by calculating the ratios using financial statements. Qualitative analysis includes inspection of notes to financial statements to verify inventory valuation methodology and consistency, investigate inventory valuation methods used by competitors, and compare them with the method used by the company.

In finance, ratio analysis is done by calculating ratios using historical inventory balances. The purpose of this analysis is to detect a company’s problems with inventory management, such as difficulty selling inventory, inventory build-up, and obsolescence. The most common inventory relationships are days of outstanding inventory, inventory turnover, and inventory / sales ratio.

The days the inventory outstanding index is calculated as inventory divided by cost of goods sold (teeth) and then multiplied by 365. This index measures the average number of days a company holds inventory before selling it. This relationship varies widely between industries and is most useful when compared to a company’s peers. If the ratio increases over time and is much higher compared to its peers, this may be a red flag that the company is struggling to clear its inventory. Holding unsold inventory is costly because money is tied up in an idle resource with no income until the inventory is sold. inventory is expensive to store, especially when it requires special handling.Also, certain inventory becomes stale and may require selling at a significant discount just to get rid of it.

Inventory turnover is calculated as the ratio of teeth to average inventory. sometimes revenue is substituted for teeth, and the average inventory balance is used. Inventory turnover is especially important for companies that carry physical inventory and indicates how many times the inventory balance is sold during the year. Similar to the days outstanding inventory rate, inventory turnover must be compared to a company’s peers due to differences between industries. a low and decreasing turnover is a negative factor; Products tend to deteriorate and lose their value over time.

The inventory to sales ratio is calculated as the inventory to revenue ratio. Some analysts use an average inventory balance. An increase in this index may indicate that a company’s investment in inventory is growing faster than its sales, or that sales are declining. On the other hand, if this ratio decreases, it may mean that a company’s investment in inventory is declining relative to revenue, or that revenue is growing. The inventory-to-sales ratio provides a big picture on the balance sheet and can indicate if a more thorough inventory analysis is needed.

In addition to ratio analysis, reading notes to financial statements is useful in inventory analysis. Because US Generally Accepted Accounting Principles (gaap) allow for different valuation methods for inventory (Lifo, Fifo, and Average Cost), a company’s management can use this discretion to manipulate its earnings. Look for any changes in accounting policies related to inventory. Frequent and unwarranted changes to inventory valuation methods can indicate revenue management.Additionally, comparing a company’s inventory valuation methodology to that of its peers can provide a common-sense check on whether company management is being aggressive with inventory valuation. Finally, look for any inventory charges, as they can identify inventory obsolescence issues.