Investment School . How to take stock of a company’s inventory

Companies engaged in manufacturing and trading goods tend to have a chunk of inventory or stock on hand at any given point in time. Knowing the right value of inventory, as on a particular date, is important, as the accuracy of both the statement of profit and loss (SOPL) as well as the balance-sheet depends on this value.

Significance

Inventory refers to the goods held by the company and includes finished goods ready for sale, semi-finished goods (work-in-progress) and raw materials used in the production of finished goods.

The value of inventory is disclosed as part of current assets under the balance-sheet. To give an accurate picture, the inventory of a company should be valued at cost or NRV (net realisable value), whichever is lower.

Every company assesses and values its inventory at the end of each reporting period and makes necessary adjustments to comply with the principle of ‘ lower of cost or NRV’.

Such adjustments impact the company’s profits in many cases. For example, Hindustan Petroleum Corporation’s (HPCL) net profit for the quarter ended December 31, 2018 was down 87.2 per cent compared to the same period a year ago.

The sharp fall was largely attributed to an inventory loss raised by fall in crude oil prices that affects the realisable value.

The value of closing stock disclosed is prone to fraudulent calculations as it could alter the company’s profitability.

The assessment of the cost and realisable value of the stock is also at the discretion of the management.

Thus, confirming the veracity of the valuation of closing stock is important as it impacts the profit of not just the reported period alone, but also the following period — the closing inventory of one period will be an opening inventory of the following period.

The accurate value of inventory is also important to guage the cash flows, the working-capital situation as well as whether the company is holding too much inventory or too little, when compared to its peers. These metrics give us an idea of the company’s liquidity position.

In the SOPL, the difference between opening and closing inventory is shown as ‘changes in inventories’ under expenses. The value of ‘change in inventories’ varies based on the production, sales, closing stock available, cost of production and the net realisable value.

A positive value of ‘change in inventories’ means that the opening stock’s value is higher than the closing stock’s. This could arise due to higher sales or lower production or drop in realisable value of the stock.

On the other hand, if the ‘change in inventories’ is negative, it means that the closing stock’s value is higher than the opening stock’s — that could arise on account of drop in sales or higher production or increase in realisable value.

In case of, say, retail industry, ‘change in inventories’ depends mostly on sales and production of the product. But in case of industries such as real estate and commodities like oil, metals, agri products — whose sales realisations depend on the external factors — ‘change in inventories’ will also be impacted by market price movement.

For instance, Tata Steel’s ‘change in inventories’ value for FY18 and FY17 was a positive ₹545 crore and a negative ₹1,329 crore, respectively.

The sharp change in FY18 was largely due to higher growth in sales than in production that led to lower closing than opening stock.

Meanwhile, in the HPCL’s example, while the ‘change in inventories’ value for the third quarter in FY19 was a positive ₹5,034 crore, it was a negative ₹1,848 in the second quarter of the same year. Lower closing value (that led to positive ‘change in inventories’) in the third quarter was mainly due to inventory losses caused by low crude oil prices that reduced the NRV.

Assess inventory movement

One can analyse the relationship between sales and inventory movement by using a metric — inventory turnover.

The ratio, which is calculated by dividing the cost of goods sold by average inventory ((opening+closing)/2) will help in identifying the number of times the company has sold the inventory and replaced.

For example, if a company’s cost of goods sold was ₹10 lakh and the average inventory held by the company was ₹50,000 in a year, the inventory turnover is 20 times.

Further, if the number of days in a period is divided by the inventory turnover, it gives inventory days — the number of days the company took to sell its inventory.

Lower inventory days is generally considered to be good as it represents faster inventory replacement due to higher sales.

Inventory turnover or inventory days help in evaluating one company’s ability to sell its inventory compared to peer players in the same industry.

For example, average inventory days of a retail company, Hindustan Unilever and a steel major, Tata Steel was around 24 days and 72 days respectively.

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