The Motley Fool: Look hard at inventory levels on a company’s balance sheet
When studying a company as a possible investment, look at its inventory levels.
Inventory refers to everything in a company’s pipeline. There are three main categories of inventory: raw materials, work in progress and finished goods. Imagine the maker of Mr. Burrito Head toys. Making the products involves ordering, receiving, storing and using raw materials, such as chemicals, cardboard and paint. These are then assembled into finished products. Inventory is likely to include vats of plastic, half-assembled burrito molds, finished boxes waiting to be shipped to distributors and returned products from retailers.
Too little inventory will hold up production when shortages occur. Too much will generate high storage costs and tie up money that could be used elsewhere. Finished goods sitting on shelves a long time also risk not being sold. In recent years, many American companies have adopted “Just in Time” inventory systems, pioneered by Ford and then the Japanese. These systems have firms holding precisely the minimum necessary inventory, replenishing supplies continually, as needed. This can increase efficiency and profitability, but can be problematic if demand spikes.
When evaluating inventory on a firm’s balance sheet, compare it with levels from the year before and with revenue growth. If inventory is rising faster than revenue, it could signal a sales slowdown. If inventory growth lags sales, either the company is not meeting demand or it’s successfully tightening controls on production processes and distribution.
To get a sense of how quickly products are flying off the shelves, calculate the “inventory turnover.” From the company’s income statement, find the “cost of goods sold.” You’ll want the last year’s worth, so add the numbers from the last four quarters. Divide that by the average value of inventory between the beginning and end of the year. (If you have problems finding these numbers, a call to the company’s investor relations department will usually get you the information you need.)
High and growing turnover numbers reflect well-managed companies freeing up funds for other uses. Compare a company’s results with those of its competitors. Kellogg’s recent turnover was 7.9, for example, vs. 5.7 for General Mills.
Ask the Fool
Q: Delta Airlines is now in bankruptcy, and its stock is trading for only about a dollar per share. I wonder whether Delta, like many other companies, might emerge as a money-making company. I suspect I’m wrong, but why? — Lin Yan, via e-mail
A: You’re right to be wary. When companies restructure themselves while in bankruptcy protection, holders of common stock tend to end up with nothing, while creditors and others might get at least some pennies on the dollar. When companies emerge from bankruptcy, they often do so with new stock, leaving the old shares worthless. Regarding Delta in particular, remember that airlines have been notoriously unprofitable businesses over the long haul. Southwest Airlines has been a rare exception.
My dumbest investment
Around 1970, I spent $4,600 on a stock called Ponderosa Systems. It was rising at a staggering pace. Back then, long-term investing to me seemed like six months. So after six months, I sold all my shares for $22,000, netting a 475 percent gain. I thought I was a genius. Had I held onto the shares for another year or so, though, my investment would have been worth more than $100,000. — Philip Cash, Eagle Point, Ore.
The Fool Responds: At least you made good money on the chain of steakhouses. You wouldn’t have wanted to hold on for too long, though, as the company eventually ran into trouble.