In the past two decades, we have seen countless companies which turned from zero to over billion rupees in market value with very limited inventories. It’s true that companies in the information sector (which only require a laptop and internet connection) doesn’t need a lot of inventories. After all, if the sole purpose of a company is running their mobile app (Android/iOS) and offering services through them, then what physical inventories they actually need apart from hosting, customer support and a few other development tools.
On the other hand, if you look into manufacturing companies which offer goods to the people/organization, inventory analysis plays a crucial role. The inventories of those companies are their most valuable current assets as they contribute directly to the source of revenue.
In this post, we’ll discuss what is an inventory and how to evaluate inventory on balance sheet.
What is an inventory?
Integratory can be defined as the goods available for sale and raw materials used to produce those goods. In other words, these can be the raw materials, goods in process and the finished goods.
There are a number of advantages of keeping sufficient inventories for a company. For example, if the company has the necessary inventories, it can quickly meet the customer orders. Stock in hand improves customer experiences. Moreover, in a few sectors, high inventories may make an attractive display and increase conversions.
On the other hand, delays in fulfilling orders, empty shelves and products out of stocks might drive away customers to the competitors. And therefore, inventory control is a key area for the company’s management to focus.
Too much inventories involve a higher cost of storage, damage issues, and insurance costs. It may also lead to increased wastage of goods if the inventories are perishable or the threat of obsolescence in case the products changes fast.
Moreover, if the company is spending a lot of money on excessive inventories, it is fixing that money which they could have used in other potentially rewarding opportunities. And that’s why excessive inventories should be controlled by the company.
How to Evaluate Inventory on Balance Sheet?
The Inventory level of a company can be evaluated by using the inventory to current asset ratio. This ratio reflects how much percentage of the current asset is kept as inventory.
Inventory to current asset=Inventory/(Current assets) ∗100
Although the ideal inventory to current asset ratio varies industry-to-industry as a few industries may require more inventories in their shelves for timely operations compared to other. However, as a thumb rule, this ratio should be less than 40%.
Moreover, try avoiding to invest in companies with inventory to current asset ratio greater than 60% as this might reflect too much inventories and the management’s inefficiency in inventory control.
For example, here is the balance sheet of Hindustan Unilever (HUL). Let’s calculate its inventory to current assets ratio.
For Hindustan Unilever, if you calculate the inventory to current assets ratio, you can find it equal to 21.23% for the year ending March 2018.
In the last 5 years, this ratio has been continuously decreasing- 30.75 (2014), 28.54%(2015), 26.87%(2016), 24.86%(2017), which means that HUL is spending less on their inventories. As the inventory to current assets ratio is still under a satisfactory level, this can be considered healthy for the company.
However, to get a better idea, you need to compare the inventory to current assets ratio of HUL with its competitors in the consumer goods segment.
Note: If you are new to the financial world and want to learn how to effectively read the financial statements of companies, feel free to check out this awesome online course on Introduction to Financial Statements & Ratio Analysis.
Although inventories are often ignored while evaluating companies in many industries, however, they are still one of the most crucial assets of a company. And that’s why inventory control is an important area to focus.
A low inventory level may lead to delays in completing orders, empty shelves and out of stocks which are not a good experience for the customers. On the flip side, excess inventory might lead to higher cost of storage, damage issues, insurance costs, spoilage costs or the threat of obsolescence. In order for a company to work effectively, its necessary to have sufficient (but not excess) inventories.