How do you analyze inventory on the balance sheet?

In accounting, inventory represents a company's raw materials, work in progress, and finished products. Financial professionals use a wide variety of quantitative and qualitative techniques to understand inventory in their investing analyses. Quantitative techniques involve performing ratio analysis of the inventory by calculating ratios using financial statements. Qualitative analysis includes inspecting notes to financial statements to check inventory valuation methodology and its consistency, researching inventory valuation methods used by competitors and comparing them to 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 ratios are days inventory outstanding, inventory turnover, and inventory to sales ratio.

The days inventory outstanding ratio is calculated as inventory divided by cost of goods sold (COGS) and then multiplied by 365. This ratio measures the average number of days a company holds inventory before selling it. This ratio widely varies across industries and is most helpful when compared against a company's peers. 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. Holding unsold inventory is costly because money is tied up in an idle resource with no income until the inventory is sold. It is costly to store inventory, especially when it requires special handling. Also, certain inventory gets obsolete and may require selling at a significant discount just to get rid of.

Inventory turnover is calculated as the ratio of COGS to average inventory. Sometimes revenues are substituted for COGS and average inventory balance is used. Inventory turnover is especially important for companies that carry physical inventory and indicates how many times inventory balance is sold during the year. Similarly to the days inventory outstanding ratio, inventory turnover should be compared with a company's peers due to differences across industries. A low and declining turnover is a negative factor; products tend to deteriorate and lose their value over time.

Inventory to sales ratio is calculated as the ratio of inventory to revenue. Some analysts use an average inventory balance. An increase in this ratio can indicate a company's investment in inventory is growing quicker than its sales, or sales are decreasing. On the other hand, if this ratio decreases, it can mean that a company's investment in inventory is decreasing in relation to revenues, or revenues are growing. The inventory to sales ratio provides a big picture on the balance sheet and can indicate whether a more thorough analysis of inventory is needed.

In addition to ratio analysis, reading notes to financial statements is helpful in inventory analysis. Because the U.S. generally accepted accounting principles (GAAP) allow 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 unjustified changes to inventory valuation methods can indicate earnings management. Also, comparing a company's inventory valuation methodology with that of its peers can provide a common sense check on whether the company's management is being aggressive with inventory valuation. Finally, look for any inventory charges, as they can pinpoint inventory obsolescence problems.