Deep Dive: Inventory

1. Introduction to Inventory

Inventory represents the goods and materials a business holds for the ultimate purpose of resale. It is a current asset on the balance sheet and is critical to a company's ability to generate revenue. For retailers, wholesalers, and manufacturers, inventory is often one of the largest and most significant assets.

Types of Inventory

Inventory can be categorized into three main types, particularly for a manufacturing company:

1. Raw Materials: The basic materials that will be used in the production process.
2. Work-in-Progress (WIP): Goods that are partially through the production process but not yet complete.
3. Finished Goods: Completed products that are ready for sale to customers.

2. Inventory Costing Methods

When a company purchases inventory at different times and at different prices, it must adopt a cost flow assumption to determine the cost of goods sold (COGS) and the value of ending inventory. The choice of method can have a significant impact on the financial statements.

First-In, First-Out (FIFO)

The FIFO method assumes that the first units purchased are the first ones sold.

• Impact in Rising Prices: Results in a lower COGS (as older, cheaper costs are used), higher net income, a higher tax liability, and a higher ending inventory value (reflecting more recent, higher costs).
• Relevance: Permitted under both U.S. GAAP and IFRS. It often mirrors the actual physical flow of goods, especially for perishable items.

Last-In, First-Out (LIFO)

The LIFO method assumes that the last units purchased are the first ones sold.

• Impact in Rising Prices: Results in a higher COGS (as newer, more expensive costs are matched against revenue), lower net income, a lower tax liability (a key advantage), and a lower ending inventory value (which can be outdated).
• Relevance: Permitted under U.S. GAAP but prohibited under IFRS. This is a major difference in international accounting.

Weighted-Average Cost

This method uses the weighted-average cost of all goods available for sale during the period to determine the value of COGS and ending inventory.
Weighted-Average Cost = Total Cost of Goods Available for Sale / Total Units Available for Sale

• Impact: Produces results that are between FIFO and LIFO. It smooths out the effects of price changes.

3. Lower of Cost or Net Realizable Value (LCNRV)

Inventory must be reported on the balance sheet at the lower of its cost or its net realizable value. This is a principle of conservatism.

• Net Realizable Value (NRV): The estimated selling price in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation.
  NRV = Estimated Selling Price - Estimated Costs to Complete & Sell

If the NRV of inventory falls below its original cost (due to damage, obsolescence, or a decline in market price), the company must write down the value of the inventory to its NRV. This write-down is recognized as a loss on the income statement in the period the decline occurs.

4. Inventory Ratios

Analysts use several ratios to assess how efficiently a company is managing its inventory.

Inventory Turnover

This ratio measures how many times a company sells and replaces its inventory over a period.
Inventory Turnover = Cost of Goods Sold / Average Inventory

• A high turnover generally indicates strong sales or effective inventory management. A low turnover might suggest weak sales or overstocking.

Days Inventory Outstanding (DIO)

This ratio measures the average number of days it takes for a company to sell its inventory.
Days Inventory Outstanding = 365 / Inventory Turnover

• A lower DIO is generally better, as it indicates the company is converting its inventory into sales more quickly.

Comparing these ratios to industry averages and historical trends is crucial for a meaningful analysis.