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Inventory means those current assets, which have been or will be converted into the final products of a company for sale in the near future. In other words, inventory represents finished goods or goods in different stages of production that a company keeps at its premises or at third-party locations with ownership interest retained until goods are sold. The three most important types of inventory are the raw materials, the work in progress (WIP) inventory and the finished goods.
Have a look at the Colgate’s Inventory breakup for 2016 and 2015. There are three types of inventory listed – raw material and supplies, work in progress and finished goods. Also, note that the majority of Colgate’s inventory is the Finished goods inventory. Is it good or bad for Colgate?
In this article, we will understand the nuts and bolts of types of inventory and its implication on Financial Analysis.
- Introduction of Inventory
- Types of Inventory
- Other types of Inventory
- Management of Inventory
- Financial Analysis of Inventory
Introduction of Inventory
Since Inventory is an asset, it is listed in the asset part of the balance sheet. And because it is most likely to get converted into revenue within a year, it is on the balance sheet under the “current assets” category. When the finished goods get sold and get converted into revenue, the carrying cost of the inventory is also reported on the income statement of the company under the item “cost of goods sold”.
For any company, especially a manufacturing or trading company, the pace of conversion of inventory into revenue is one of the most important factors because it directly decides how much revenue the company is earning or will earn. For a trading company, the inventory is called “merchandise” because there no conversion is taking place. A trader merely buys and resells the finished goods bought from the manufacturers.
source: Amazon SEC Filings
As we see from above, Amazon’s lists the seller’s inventory on its marketplace. However, these third part sellers maintain ownership of inventory and therefore such products are not included in Amazon’s inventory.
The pace at which the inventory gets converted into finished goods and the finished goods get sold and get converted into revenue is also called inventory turnover. Thus, inventory turnover is very important for a company since it is the biggest contributor to a company’s revenue generation and the subsequent generation of value for the investors. That is why, having the understanding of inventory, its management, and its analysis is very important for an analyst as well as an investor in a company.
Types of Inventory
As mentioned above, the three most important types of inventory are the raw materials, the work in progress (WIP) inventory and the finished goods. There are a few other categories into which other items representing a company’s inventory can be classified. So let us first have a basic understanding of the different types of inventory and later we will look at their ways in which they are managed and analyzed.
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Following are the different types of inventory:
#1 – Raw Material Inventory:
Raw materials are the basic materials that a manufacturing company buys from its suppliers and that are used by the former to convert them into the final products by applying a set of manufacturing processes. For example, aluminum scrap is the raw material for a company that produces aluminum ingots. Flour is the raw material for a company that produces bread or pizza. Similarly, metal parts and ingots are the raw materials bought by a company that manufactures cars and crude oil is the raw material for an oil refinery.
It is very common and easy to observe that the final products of one company are bought as raw materials for some other company. For instance, many oil drilling companies produce crude oil as their final product. On the other hand, the same crude oil is bought by oil refining companies as raw materials in order to produce their final products i.e. gasoline, kerosene, paraffin etc.
source: BP Annual Reports
As we note from BP annual report, Crude Oil and Natural Gas are the raw material inventories included in the Types of Inventory Classification.
It is important to optimize the raw material inventory. This is because if a company keeps too much of raw material inventory in stock, it will incur higher carrying costs and there is also the undesirable possibility of the inventory getting obsolete. For example, in pharmaceutical or food industry, the raw materials may be perishable. If not used within a stipulated time limit, they can get expired and can’t be used in production. On the other hand, a company must have a certain minimum level of inventory at all times to cater to the production volumes, which mostly follow the trend of the market demand. Thus, optimization of raw material inventory is important.
#2 – Work in Progress (WIP) Inventory
Work in progress inventory can also be called semi-finished goods. They are the raw materials that have been taken out of the raw materials store and are now undergoing the process of their conversion into the final products. These are the partly processed raw materials lying on the production floor. And they have also not reached the stage where they have been converted into the final product.
The extent of inventory locked-up as work in progress is lower the better. This is understandable as the inventory under process is of no use till it gets converted into the final product. It may be saleable at some price but it cannot be sold to generate any revenue for the company’s core business. In fact, in lean manufacturing systems, the work in progress inventory is considered as waste.
So it is most desirable that the volume of inventory that is lying in the form of work in progress be minimized and the time is taken to convert it into the final also be minimized so that the locked-up value can be released as quickly as possible. The idea is that this capital, which is locked-up in the form of work in progress inventory, can otherwise be invested somewhere else in order to achieve much better returns.
#3 – Finished Goods Inventory:
Finished goods are indeed the final products obtained after the application of the manufacturing processes on the raw materials and the semi-finished goods discussed above in the article. They are saleable and their sale contributes fully to the revenue from the core operations of the company.
Regarding the level of finished goods inventory, there are two types of industries that we need to look at. First, we would take the industries in which the finished goods are mass produced and the sale happens after the production. Examples of such industries are the FMCG industry and the oil industry. For a company in such an industry, the correct approach is to maintain the finished goods inventory in a similar manner as the raw material inventory is maintained i.e. at an optimized level as per the demand in the market.
Ford is reducing its finished goods inventory by trimming production. As we note above, Ford had a supply of only 78 days in February as compared to 97 days of stock in January.
The other type of industries is one in which the goods are manufactured on demand i.e. the order is first received and then the production starts. An example of such industries is the capital goods industry and the customized goods industry. For a company in such an industry, it is neither necessary nor advisable to keep any inventory of finished goods because their finished goods kept ready in stock might never get sold even if they have the slightest deviation from the specifications of the new orders coming from the customers. So they may never get a return on their investment gone in making the finished goods ready.
Other types of Inventory:
There are two other important types of inventory, namely packing material inventory and MRO (maintenance, repair and operating) supplies inventory.
As the name suggests, the packing inventory is the inventory of the materials that are used by the company to pack the goods. Within this category, there are something called the primary packing inventory and the secondary packing inventory. Primary packing is something, without which the goods can’t be used. For example, the tube of an ointment is its primary packing.
Secondary packing is something used to pack the goods so that they don’t get damaged during handling, transportation etc. or to make the goods appear more appealing to the customers. For example, the carton used to pack the tube of an ointment is its secondary packing.
MRO supplies or simply supplies or consumables are those materials that are consumed in the production processes but do not form a part of the finished goods or form a very small part of the finished goods. They are a type of supporting materials for the production process. The maintenance and repair supplies include the lubricating oil, coolant, bolt, nuts etc. that are used during the production of various machines and machine components. Operating supplies include the stationery and office supplies used by a company.
Management of Inventory
In our discussion of the types of inventory, we explained that apart from the work in progress inventory, all other types of inventory must be held at optimal levels. And by optimal, we mean neither too high nor too low. For doing so, a company needs to find that level of inventory at which it has to incur the minimum total cost, which is the sum of certain component costs including ordering cost, purchase price and carrying cost etc.
Taking these costs and the market demand into consideration, a company can decide an economic order quantity (EOQ) and create an inventory purchasing plan to ensure that items are available when they are needed while they are not lying in the stores in unnecessary quantities.
The two popular and highly practiced strategies for inventory management used in industry are the just-in-time (JIT) and materials requirement planning (MRP). In JIT, the arrangement between the vendors and the company is such that the latter receives the raw materials at near about the same time when it needs them for production. On the other hand, in MRP, the raw material delivery is schedules based on the sales forecast.
Financial Analysis of Inventory
There are quantitative as well as qualitative techniques that are used by analysts and investors in order to have an understanding of the inventory movement of within a company.
#1 – Quantitative analysis – Inventory Days Ratio
Under the quantitative techniques, the inventory related numbers reported in the financial statements of a company are used to calculate certain ratios and perform the ratio analysis. The common ratios used to perform the ratio analysis regarding the inventory management of a company are inventory days, inventory turnover and inventory to sales ratio.
The first ratio i.e. inventory days outstanding is equal to inventory (mentioned in the balance sheet) multiplied by 365 divided by cost of goods sold (COGS; mentioned in the income statement). Therefore, if the inventories of a company ABC at the end of the year 20XX are $ 14,386 million and its COGS for the same year is $ 287,607 million, its inventory days ratio will be equal to:
Inventory days = ($ 14,386 million*365/$ 287,607 million)=18.26 days.
This implies that the company holds inventory for an average of 18.26 days between the point in time when it buys it and the point in time it sells it. If the ratio increases over time and is much higher compared to its peers, this can be a red flag that the company is struggling to clear its inventory.
Let us compare Colgate’s Inventory days outstanding with that of Procter & Gamble.
- We note from the above chart that Colgate has an Inventory days outstanding of 70.66 days as compared to Procter & Gamble’s Inventory days of 53.76 in 2016.
- Since 2011, Procter & Gamble has been consistently reporting a better Inventory days outstanding numbers than that of Colgate.
Next, the inventory turnover ratio is equal to the sales achieved by the company over a period divided by the average inventory for that period. For example, if the beginning inventory for the year 20XX is $ 14,386 million and the ending inventory is $ 18,378 million, the average inventory will be $ 16,382 million. Now, if the sales of a company for the same year is $ 391,569 million, the inventory turnover will be equal to:
Inventory turnover = ($ 391,569 million/$ 16,382 million)=23.90
This implies that in a year, the inventory of the company gets turned over approximately 24 times. Many analysts use COGS instead of sales in for finding the inventory turnover ratio. This approach is more accurate since it does not include the markup charged by to its customers, which is irrelevant in inventory analysis. If this ratio is declining or is low compared to the peers, it gives a negative sign to the investors.
The inventory to sales ratio is just the reciprocal of the inventory turnover ratio when sales is used instead of the COGS in the numerator. An increase in this ratio indicates the company is locking up more and more capital in inventory as compared to the revenue that it is generating.
#2 – Qualitative analysis:
Under the qualitative analysis techniques, an analyst reads the notes to financial statements and tries to understand the inventory valuation methods used by the company. He then compares these valuation methods with those used by the company’s peers and also looks for any changes in inventory accounting policies made by the company for the purpose of manipulating the reported financial numbers.
There are three different inventory valuation methods that a company can use at its discretion. They are the LIFO (Last In First Out), FIFO (First In First Out) and Average Cost methods. Depending upon the valuation method used, the COGS as well as the value of the inventories reported on the balance sheet vary.
As we note from above, Amazon uses FIFO for inventory valuation.
This also affects the financial ratios described above. Due to this, the consistency and justification of the valuation method being used by the company are very important. Otherwise, they will easily lead to the manipulation of reported earnings and will mislead the investors. Therefore, an analyst doing qualitative analysis must have a good eye to catch the inconsistencies or frequent switching from one method to another.
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Inventories are the assets that will be of have been converted to the final products of a company. They are of three major types, namely raw materials, work in progress and finished goods. The management of inventory calls for an optimum level of inventory that can be maintained by creating an inventory purchasing plan as per the strategy adopted by the company.
Inventory analysis can be quantitative or qualitative. The former uses ratio analysis which includes historical as well as peer comparison. The latter technique uses the information regarding the inventory valuation method used by the company for reporting its inventories. By carrying out both the types of inventory analysis, an analyst can get a good idea of how well or poorly a company has been its various types of inventories.