In: Accounting
If a company were having inventory problems (producing too many items), how would it affect their financial statements? Would there be any negative or positive finanical impacts?
* 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.
The days inventory
outstanding ratio is calculated as inventory divided by
cost of goods sold (COGS) times 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 it.
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 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.
-Based on the above provided facts
inventory can either have positive/negative impact on financial
statements.