Behind The Numbers - Aggressive Inventory Management

Inventory is the second most important factor for earnings quality analysis.

The longer inventory ages, the greater the possibility that the company is misallocating cash, misjudging the market and may have to write down inventory.

Inventory affects profitability via gross margin on the income statement and shows demand for a company's products.

Days Sales in Inventory = (91.25 x Inventory/Quarterly Cost of Goods Sold).
Days Sales in Raw Materials = (91.25 x Raw Materials/Quarterly Cost of Goods Sold).
Days Sales in Work in Progress = (91.25 x Work in Progress/Quarterly Cost of Goods Sold).
Days Sales in Finished Goods = (91.25 x Finished Goods/Quarterly Cost of Goods Sold).

In addition to inventory on the balance sheet, the company also records deferred income to distributors, to whom it affords rights of return and price protection for products they don't sell. While deferred income represents some future revenue, in some company's cases it also represents inventory sitting in the sales channel that has yet to be sold and is at risk.

Tracking inventory component divergence gives the investor advance notice of good and bad performance. Focus on negative divergences wherever you find them and understand the business.

Positive divergence occurs when a company knows that business ahead is good, so its raw material inventory picks up while work in progress and finished goods either lag or do not increase at the same rate.

Investors want to avoid negative divergence when finished goods pile up in excess of sales while raw material inventories and work in progress are flat or declining absolutely or relative to sales.

Charlie Munger on technological advances bring products and favorable declining prices that benefit consumers and not shareholders of the producers.

Rising inventory by itself is no indicator of problems. What matters is inventory buildup relative to other factors.

If aging inventory is a greater percentage of total inventory, then mark-downs, write-downs, and obsolescence have a more servere impact. This is especially toubling with consumer products.

LIFO reserve changes - Changes from one method to another for any purpose, such as valuing reserves, are cause for concern. When a reserve is reversed, its a credit to the income statement. Essentially it is 100% margin, so the EPS boost is significant.

The retail method of inventory valuation recognizes markdowns as the products are sold, while the average cost measures markdowns when made. The change from average cost to retail method stretches out the period between markdown and actual reduction in inventory value.