The basic operation of a business is centered around 2 steps:
- Build a Product
- Sell that product
And I would argue that step #2 is the most important. Of course quality of your product is important, but if your product isn’t selling – the business is not making money. Period.
Today we are going to look at a few ways to analyze the inventory on a company’s balance sheet to help us measure how well the company is doing selling its product.
Inventory is usually the largest current asset on a company’s balance sheet, and is therefore the company’s primary use of cash. We have all seen the new companies on Shark Tank who desperately need money for inventory (Or who have used up all their capital buying inventory). So learning a few basics on what a company’s inventory is telling you is very important.
Keep in mind, the effectiveness of this type of analysis is really only fitting for select industries. The inventory of a software company will tell you very little, while the inventory of a manufacturer or retailer can be very important.
In general, if the company is built around selling a tangible product, this type of analysis is important. Think manufacturing and retailers over service providers.
First up, breaking down a company’s inventory into its components:
One of the best discussion I have seen regarding analysis of a company’s inventory comes from Thorton O’Glove in his book Quality of Earnings
O’Glove gives a few ideas on what to be on the lookout for:
First, O’Glove looks at a few of the components that make up the total inventory on a company’s balance sheet and how they relate to each other.
O’Glove looks for an increase in raw materials on a company’s balance sheet, which can mean business is picking up, and may be reflected in rises in future profits. O’Glove refers to this as “Positive inventory divergence”. He goes on to say:
“The positive version transpires when the raw materials component of inventories is advancing much quicker than the work-in-progress and finished goods components. Imagine what this might mean. The company receives many new orders, and management realizes that an inventory buildup is required. So it simultaneously ships products from its finished goods inventory (which declines) while ordering raw materials in larger amounts (so this component of inventories is enlarged). This, of course, is good news, and should trigger bullish impulses in your psyche.”
However, a rise in finished goods instead of raw materials can be a sign that the company is not selling its product. O’Glove calls this “negative inventory divergence”.
Before we start some analysis – we need to know where can this information can be found. A quick look at a company’s balance sheet only shows one line dealing with inventory:
You will have to look (usually in the ‘Notes’ section of the report) for where the company breaks down the components of its inventory. Something like this:
In his book, O’Glove gives an example from Commodore International’s 1983 and 1984 balance sheets.
“It didn’t take too much imagination to figure out what was happening at CBU. Raw materials, in this case the electronic components, were being assembled into microcomputers and related gear, which despite an intense sales campaign were piling up as inventories of finished goods. Given the relationship between these two sets of figures, it isn’t too difficult to see that the dollar figures for the finished goods component of inventories on September 30, 1984 were too high”
So, I wanted to do this type of analysis on one of companies that appeared on our latest Ben Graham Screen and see what we can learn from a quick analysis of their inventory.
Strattec Security Corp (Ticker STRT): Strattec is a producer of locking devices and other mechanical parts for the automotive industry. The automotive industry in general is booming right now, and many are wondering how long the bull market for autos can last. Maybe keeping an eye on Strattec’s inventory can give us a clue when products just aren’t selling and give us a heads up on an auto industry slowdown.
Remember, Strattec came through Ben Graham’s Enterprising Investor screen, which means that it has a history of positive earnings over the last 5 years, a current ratio of greater than 1.5, pays a dividend and is trading at less than 1.2x Tangible book value.
These companies are cheap, so don’t expect perfect financial statements. But maybe if we can see that Strattec is still selling a decent amount of locking devices without a huge buildup in inventories, we can feel more comfortable investing.
Does a quick analysis of Strattec’s inventory give us a reason to worry? I set up a spreadsheet just like O’Glove did in his book to analyze the last year of Strattec’s inventories:
(click to enlarge)
This spreadsheet template for the image you see above, and others below, is available for download from us for free. Simply replace the inventory numbers with those of another company to quickly identify trends and potential problems. The Excel file is free in exchange for a like, tweet or +1:
[sociallocker]Thank you! Download the Excel template here: Begin To Invest Template for Inventory Ratio Analysis[/sociallocker]
Upon initial review, it doesn’t appear Strattec is experiencing a huge spike in total inventory, or any significant buildup in finished products or raw materials. The slight drop in earnings is due to a very good previous quarter and most importantly we are not seeing a huge buildup in finished goods.
Compare that to another company, Terra Nitrogen (Ticker: TNH)
(Click to enlarge)
Here we are seeing something possibly concerning. Terra Nitrogen’s finished inventory has more than doubled (and was up significantly the quarter prior as well), while also coinciding with a drop in raw material orders and sales.
Terra Nitrogen is in the business of selling fertilizer. So, I imagine business is seasonal – farmers are applying more fertilizer in certain seasons compared to others. But looking back over the last 5 quarters, the drop in sales during this time period and rise in finished good inventory from the most recent quarter is unprecedented. It is certainly worth a deeper look and should be considered at least a warning sign.
A Quick Note on Seasonality
I did find that it is important to at least take a look back over a complete business cycle when doing this type of analysis. For example, when I first started to look at 1-800-FLOWERS balance sheet, I thought there was something very concerning:
This looks like your typical case of a company that has produced too much product and is dumping product onto retailers (because receivables have skyrocketed as well).
But once you take a step back and look at the past 5 quarters, it becomes more apparent that 1-800-FLOWERS does a huge portion of their business in a single quarter, so their balance sheet reflects a buildup in inventory for the sales season.
This does not mean 1-800-FLOWERS is out of the woods. They do have a steep increase in finished goods that need to sell, but that buildup should be expected and it seems worthwhile to wait a quarter and see how the inventory moved before making any drastic investment calls.
How well does this type of inventory analysis work? O’Glove says:
“had investors been monitoring these figures (inventory and accounts receivable) on a quarter-by-quarter basis, they could have predicted the collapses in the price of perhaps four out of every five stocks which occurred during the high tech washout in 1984-1985. Fast growing industries are always subject to such shakeouts”.
Ben Graham, in his book The Interpretation of Financial Statements said of inventory turnover:
“The chief criterion of inventory soundness is turnover, defined as the annual sales divided by year end inventory…The comparison of inventory turnover among companies within an industry will in many cases reveal an important competitive advantage which marks the leading companies in the group.”
In order for a company to make money, it must convert inventory into cash. Measuring a company’s inventory turnover looks at just that.
Inventory turnover measures how long it takes for a company to turn raw materials into sales of a finished product. Consider 2 companies that sell the exact same product for the same margins (that is, they make the same amount of money on each sale). Does that imply that these companies should be valued the same? Obviously not because we don’t know how much each company sells.
Ben Graham used the definition:
If we calculate that a company has an inventory turnover ratio of 2, it means that the company sold its inventory twice in that period (usually annually). Or put another way, if using an annual period, it takes the company 180 days to turn raw materials into a finished product and sell that product.
Graham specified end of year inventory (Though really, turnover can be measured between any time frames as long as you have the data, such as monthly or quarterly).
Average inventory is calculated as the sum of the inventory at the start of the period:
Consider the last 2 10-k’s from Strattec. Specifically the company’s inventory:
So Strattec’s average inventory would be: 38,683,000 + 34,786,000 / 2 which equals $36,734,500
Then divide the company’s sales over that period of time by its inventory:
$401,419,000 / $36,734,500 = 10.92. Meaning the company turned over its inventory about 11 times during the year.
We can compare that to Strattec’s competitors and see how they compare. A higher inventory turnover ratio is better. A low ratio can be due to an inventory buildup (Which may be a sign of slowing sales, or the company building up inventory for future sales) or simply poor inventory management.
A higher turnover number also means the money that the company invests in inventory is not “locked up” for as long. If a Strattec competitor of the same size and sales has an inventory ratio of 5 (compared to Strattec’s 11), it is effectively using twice the investment in inventory to get the same results as Strattec. A higher inventory ratio frees the company up to being able to deploy money to other areas that may get a higher return.
A Different Calculation for Inventory Turnover – Using Cost of Goods Sold
However some use a different definition of Inventory Turnover. Instead of calculating inventory turnover with sales, they use Cost of Goods Sold (CoGS). In our example with Strattec’s income statement above, we can see Strattec’s CoGS was $336,594,000.
We can plug CoGS into the inventory turnover equation:
$336,594,000 / $36,734,500 = 9.16
Just like when using sales, a higher number is better. So why do some prefer to use sales while others use Costs of Goods Sold to calculate inventory turnover?
First, I would take a guess that Graham used sales because that was the only information he could reliably get in his time. Even today not every company will report Costs of Goods Sold.
But the other reason is that a company’s inventory is reported on the balance sheet at cost. That is, inventory is reported at the price the company paid for the materials, not what they are going to sell them for.
So when you want to calculate the turnover of that inventory, you want to use Costs of Goods Sold because it is also based on the cost of the products sold, not what the products are sold for.
If you use sales, you are factoring in the company’s gross margins into your inventory turnover calculation.
Many prefer using Costs of Goods Sold, but I still like the way Graham did it. Here’s my reasoning:
Take a look at two example companies and how the two different definitions for inventory turnover could affect your judgement.
Company 1 – Has very high gross margins on its product (90%)
Company 2 – Has lower gross margins on its product (50%)
Using sales in your formula for inventory turnover, both companies have an inventory turnover ratio of 5.
But using Costs of Goods Sold, Company 1 has a 0.5 inventory turnover ratio, while company 2 has a 2.5 inventory turnover ratio.
So Company 2 is the better investment right?
I’m not sure it’s so clear.
This quick analysis does quickly determine that company 1 has big time inventory management problems. Based on their 0.5 inventory turnover ratio, they have 2 years worth of inventory stocked away. Not good.
But it is hardly an “end-all-be-all” analysis.
All other things equal – Company 2 obviously has an advantage, but in our scenario above if you simply calculated an inventory turnover ratio and made an investment based on that, you may be missing out.
Company 1 is making much more money than Company 2. And Company 1 likely has a much more proprietary product since it is able to keep such high margins – a sure sign of a competitive advantage.
This type of analysis was able to identify a weakness of Company 1, but it certainly does not explain the whole story. I think in general I would rather invest in a company with higher margins and stronger competitive advantage with a solvable inventory problem than a company that has better inventory management but has much less profits.
Like most indicators, inventory analysis provides a peek into the health and operations of a company. But it can hardly be looked at as the sole indicator of a company’s success.
This analysis only works when comparing companies within the same industry and, as we saw above, with similar profit margins. Also, the trends from this data is much more useful than the numbers from any single quarter or year, as we saw in our 1-800-Flowers example above.
But being able to do this analysis is still incredibly important. I bet determined investors who use this type of analysis will be much more likely to spot the top in a few industry cycles that are booming right now. Try keeping track of some numbers from Aerospace parts companies, or automotive part companies, or smartphone part companies. Investors with a persistent eye on inventories may be clued in to the next down leg in the markets.