Inventory disclosures, turnover and days of inventory

What do the inventory notes tell you?

They tell you how inventory is measured, how much there is and of what kind, what was written down and what is pledged. These inventory disclosures are the analyst’s first source, because the balance sheet shows only one line.

International Financial Reporting Standards (IFRS) require, in the notes: the accounting policies and the cost formula used; the total carrying amount and the amounts by category (merchandise, raw materials, production supplies, work in progress, finished goods); the amount carried at fair value less costs to sell; the amount expensed in the period (cost of sales); the amount of any write-down; the amount of any reversal of a write-down and the circumstances that led to it; and the inventory pledged as security for liabilities.

US generally accepted accounting principles (GAAP) are similar. The reversal items disappear, because reversals are prohibited. They add the significant estimates that apply to inventories and any material income from the liquidation of last in, first out (LIFO) inventory.

Inventory disclosuresIFRS list; US GAAP is similar

• Method Memorize
  • Cost formula and policies
• Amounts Memorize
  • Total carrying amount and by category raw materials, work in progress, finished goods
  • Carried at fair value less costs to sell
  • Expensed in the period cost of sales
• Write-downs Use it
  • Write-downs expensed
  • Reversals and their reasons IFRS only
• Claims Use it
  • Inventory pledged as security
• US GAAP additions Know the idea
  • Significant estimates
  • Income from LIFO liquidation

Beyond the notes, read the management discussion and analysis, industry news and publications, and economic data such as order backlogs or commodity price indexes. They show whether a rise in stock is planned or a symptom.

Exam tip A question asking what is not required will list a plausible-sounding item, such as replacement cost by category. Check each option against the list of eight.

How do you read the inventory categories?

Look at which kind of inventory is growing, not only how much. A manufacturer holds raw materials , work in progress and finished goods , and the mix moves with the flow of production and sales.

Pattern	Likely signal
Raw materials and work in progress rising, finished goods steady	Management expects higher demand
Finished goods rising faster than sales	Weakening demand, possible future write-downs
Total inventory growing faster than sales	Warning sign
Frequent write-downs	Obsolescence or poor forecasting

Reading inventorycompare with sales growth, the industry and the notes

• Possibly good Use it
  • Raw materials and work in progress rising, finished goods steady expected higher demand
  • High turnover with sales growth at or above peers efficient management
• Possibly bad Use it
  • Finished goods rising faster than sales weak demand
  • Low turnover, high days on hand slow-moving or obsolete stock
  • Frequent write-downs obsolescence, poor forecasting
  • High turnover with slow sales growth too little stock, or a write-down

How do you calculate inventory turnover and days on hand?

Divide cost of sales by average inventory to get turnover, then divide 365 by turnover to get days. Inventory turnover says how many times a year the stock is sold and replaced. Days of inventory on hand says how long a unit sits before it is sold. The two are inversely related.

$$Inventory_{avg} = \frac{Inventory_{begin} + Inventory_{end}}{2}$$

$$\text{Inventory turnover} = \frac{\text{Cost of sales}}{\text{Average inventory}}$$

$$DOH = \frac{365}{\text{Inventory turnover}}$$

Cost of sales goes on top because inventory is carried at cost. Revenue includes the profit markup and would overstate turnover.

Exams ask this from every side: a turnover and an inventory, and you want the days; or days and cost of sales, and you want average inventory.

$$\text{Gross profit margin} = \frac{\text{Revenue} - \text{Cost of sales}}{\text{Revenue}}$$

The gross profit margin shows the share of each sales dollar left after the goods themselves. Normal levels vary a lot by business. A grocer lives on thin margins and fast-moving shelves; a jeweler earns wide margins on stock that sits for months. More competition usually squeezes the margin. So compare a company only with peers that sell the same kind of product.

How should you interpret the ratios?

Never read turnover alone. The same number has a good story and a bad story, and two checks decide between them: how fast sales grow against peers, and what the notes say about write-downs.

What you see against peers	Plus	Most likely story
Turnover high, days on hand low	Sales growing at least as fast as peers, few write-downs	Stock is managed well
Turnover high, days on hand low	Sales growing more slowly than peers	Shelves too thin: lost sales or stalled production
Turnover high, days on hand low	Large or repeated write-downs	The ratio is flattered by a smaller inventory figure
Turnover low, days on hand high	Sales flat or falling	Slow-moving or obsolete stock

Method matters too. A LIFO company in a period of rising costs shows a higher turnover than an identical first in, first out (FIFO) company, only because its inventory is carried at old costs. Allow for that before you compare, using the LIFO reserve from the FIFO, LIFO and weighted average lesson.

An inventory valuation allowance lets you do this from the published notes. The allowance is the total of write-downs still held against the inventory, and the balance sheet shows inventory net of it.

$$Inventory_{gross} = Inventory_{net} + \text{Valuation allowance}$$

Add the allowance back to get inventory at cost, and use the change in the allowance, together with the write-down disclosure of the charge for the year, to restate cost of sales. Rising write-downs over several years are a warning sign in themselves.

Go deeper Debt covenants and write-downs

Loan agreements often include ratio limits, for example a minimum current ratio. A write-down lowers the current ratio and equity and raises debt-to-equity, so a large one can cause a covenant breach even though no cash moved. Analysts should watch for possible write-downs where a company is close to its limits, and in industries where technology makes inventory obsolete.

Go deeper From days of inventory to the cash conversion cycle

Days of inventory on hand is the first piece of the cash conversion cycle: days of inventory on hand plus days of sales outstanding minus days of payables outstanding. It measures how long cash is tied up between paying suppliers and collecting from customers. The working capital module builds on it, and the financial analysis techniques module covers the other two components.