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How Understanding Inventories Can Help You Analyze Company Quality

how to analyze inventory ratios
How Understanding Inventories Can Help You Analyze Company Quality
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Inventory analysis can be best explained by way of an example.

Assumptions

1. You are a manufacturer of goods (this post is not applicable for the services sector) and have just started a factory.

2. You have invested in plant and machinery.

3. You estimate that if you process Rs 1,00,000 worth of raw material, you will get 10,000 (so, cost is Rs 10 per piece) units of finished goods that can be sold in the market for Rs 1,60,000 (or, Rs 16 per piece).

4. It takes 30 days for your finished goods to be completely sold.

Gross Profit Margin 

You invest Rs 1,00,000 into stocks, make 10,000 units, and and sell the finished product at Rs 1, 60,000 (Rs 16 per piece).

You pay wages to factory workers of Rs 3,000, a power bill of Rs 2,000 and plant maintenance of Rs 2,000.

Therefore, your gross profit is Rs 53,000, or 33% of sales (53,000/1,60,000 X 100) or 53% on raw material cost (53,000/1,00,000 X 100).

Now, from this gross profit, you pay transport charges of Rs 4,000 and packing charges of Rs 4,000, leaving you with a net profit before depreciation and interest, of Rs 45,000. These expenses are related to sales/office and not to production, and therefore these are not deducted while arriving at the gross profit.

Types of Inventory 

When you convert raw material into finished goods, then at any given date, your inventories will be made up of:

a. Raw material – which you hold for future orders

b. Work in progress – raw materials that are in the production cycle but have not yet been converted to finished goods

c. Finished goods – goods that are ready for despatch against orders + goods that you have manufactured in anticipation of future orders + goods that you would like to stock because of any seasonal spike in demand or because raw material cost will increase, or for whatever reason.

Inventory Levels & Valuation

If you’ve been following the post, you already know that it takes 30 days for your finished goods to get sold in the market.

Now, you are a prudent businessman and are aware that credit will have to be extended to buyers, and therefore you decide to maintain the following levels of stocks (valued at cost):

(a) 10,000 pieces of finished stock with retailers (these are already booked as sales)

(b) 10,000 pieces of finished stock as a buffer for future orders

(c) 2,000 pieces as work-in-progress

(d) Rs 50,000 worth of raw material

Therefore your inventory valuation at the end of every month, and also at the end of the year, would be:

10,000 pieces of finished goods valued at cost: Rs 1,00,000.

2,000 pieces work-in-progress valued at Rs 22,000 (cost of raw material would be Rs 20,000 and Rs 2,000 is assumed as cost of work in progress in factory)

Raw material of Rs 50,000 at cost.

Therefore, the assumption now is that your inventory would be valued at Rs 1,72,000 at the end of every month and therefore also at the end of every year.

Sales & Optimum Inventory

Going by the above assumption, your sales per month are Rs 1,60,000.

That gives us Rs 19,20,000 sales in a year (1,60,000 X 12)

And, from above, your optimum inventories at the end of the year are Rs 1,72,000. These levels of inventories are comfortable enough to meet future requirements, service existing clients and keep costs static.

Analyzing Inventories

Now, assume your inventory levels are not Rs 1,72,000 at the end of the year, but something else.

Scenario 1:

Your inventories are Rs 46,200 made up of Rs 4o,000 (4,000 pieces of finished product), Rs 1,200 work in progress (100 pieces) and Rs 5,000 worth of raw material.

These are very low compared to your optimum levels. What can such low levels imply?

(a) That the demand for your products has suddenly shot up leaving you with no room to plan.

If this plays true, your sales should shoot up perhaps after a gap of 15 days to 1 month

(b) You have no money to stock raw materials or finished goods (maybe because competition is intense or because your debtors have defaulted or you’ve been swindled by an employee, etc.).

If this plays true, your sales should drop and/or your borrowing should increase until you optimize your product mix or recover the monies due.

(c) That your goods are not well received in the market and the stocks with retailers are building up, and you are thinking of optimizing the product mix.

If this plays true, your sales should drop until you rework the product line.

Whatever the case may be, the impact of low inventories at the end of the year will play out in the month-on-month sales. If sales start popping it is a good sign, if these remain the same or reduce, you must figure out what’s going on by calling the company’s CS.

Scenario 2:

Your inventories are Rs 2,75,000 made up of Rs 2,00,000 (20,000 pieces of finished product), Rs NIL work in progress and Rs 75,000 worth of raw material.

These are very high compared to your optimum levels. What can such low levels imply?

(a) That the demand for your products has suddenly dropped or there’s some defect in your product and that has hurt sales or technological obsolescence has hit your products.

If this plays true, your sales start dropping immediately.

(b) You have very badly estimated demand and have manufactured extra inventory. Or, you are overstating inventory. Or, you just got hammered by the competition and you went on ignoring it and kept n piling stock in the hope of better things to come.

If this plays true, your sales should drop and/or your borrowing should increase until you become a better manager or match the competition. This impact will play out in the sales.

(c) That you have feelers from retailers that demand for your goods is fast increasing and therefore you have stocked up anticipating better days.

If this plays true, your sales should start zooming within 1-2 months of the stock pileup.

Scenario 3: This is the best case scenario and it implies steady demand and efficient inventory management.

I think it is safe to assume that you have understood the concept. Now it’s time to understand financial ratios.

Inventory Ratios and their Analysis

Inventory Days: How many days does it take to sell inventory

From the above: Your sales are 19,20,000 per year or Rs 1,60,000 per month, or Rs 5,333 per day (1,60,000/30)

Gross Sales margin is 33%. Therefore your cost of goods sold per day is 3,573 per day.

Your inventories at the end of the year are valued at 1,72,000.

This means that you are holding 49 days of inventory.

Typically, inventory levels depend on the business. For example, a jewelry company can hold 4 months inventory, a FMCG company that sells high-demand products can stock up even more, while a smaller company will hold inventory for a lesser period.

However, the inventory days should be comparable and not abnormal. If these seem abnormal, you shroud inquire into the reasons why.

Inventory Turnover: Calculates efficiency

The formula for this ratio is (cost of goods sold) divided by (opening inventory + closing inventory/2).

Let’s calculate the cost of sales from the numbers above:

Raw material purchases Rs 13,00,000 (including the extra raw material purchased for future sales)

Power, wages and plant maintenance: Rs 84,000

Total cost of sales = Rs 13,84,000

Therefore, the inventory ratio in your case is 13,84,000/ (1,00,000 +1,72,000/2) =  10.17

This suggests that you turned over 10.17 times in a year, which shows you are an extremely efficient manager.

Low inventory ratios imply that management is not very efficient in converting inventory to sales.

Inventory ratios tell you what has happened in the past. If you come across any anomaly you must immediately call the company to find out what’s going on.

Reread this post and apply it to an Annual Report and practice analyzing inventories and ratios to judge company efficiency.

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