7.7 Inventory Analysis

As mentioned previously, inventory can be a significant asset for many businesses, as it represents profit-generating potential. Buying or producing goods at a certain price and then selling them for a higher price is the essence of the retail, wholesale and manufacturing sectors. Obviously, efficient management of these inventories is essential for the success of the business. A company needs to control the cost of inventories in order to maintain its profit margins. As well, companies need to ensure that inventories move through the system quickly. Inventories sitting in a warehouse, unsold, are not producing profits or cash flow for the company. While the items sit in the warehouse, the company will incur costs: the cost of the warehouse space itself and the cost of funds required to finance the inventory. Obviously, to minimize these costs, it is important to sell the inventory as quickly as possible, while maintaining the desired margin.

To analyze inventory, we will look at two types of ratios: gross profit margin and inventory turnover period.

Gross Profit Margin

Gross profit represents the difference between sales revenue and cost of sales. This is an essential measurement in determining the profitability of a business, as it represents the profit generated by the primary business activity of selling goods, before considering any other expenses. To facilitate comparisons between different sales volumes, the gross profit margin is calculated as follows:

By expressing this relationship as a percentage, one can make comparisons between different companies or different accounting periods for the same company. This is a type of common size analysis that helps the reader discern relationships and trends that may indicate something about the company’s profitability. Consider the following example from the financial statements of a large automobile manufacturer (in $ millions):

Sales declined slightly in 2021 compared with the previous year, as did gross profit. By calculating the gross profit margin, we can get a better idea of the meaning of these results:

Gross profit margin 2021 = 9.40%

Gross profit margin 2020 = 10.56%

Although the gross profit margin dropped by only 1.16 percent between years, this rep- resents lost profits of approximately $1.5 billion on this scale of revenues. Management would obviously be motivated to find ways to control these margins to prevent further declines, whether through adjusting sales prices or controlling costs better.

Inventory Turnover Period

Aside from the profitability of the business’s core activities as calculated above, management is also interested in the efficiency of carrying out those activities. One way to measure the efficiency of inventory movements to calculate the inventory turnover period:

This ratio will help us understand how quickly the company moves inventory through the various business processes that eventually result in a sale. For a manufacturing company, this process begins with the receipt of raw materials and ends when the finished goods are finally sold. Once again, consider the reported inventory levels of the automobile manufacturer (in $ millions): 2021–$7,860, 2020–$7,700, 2019–$7,360.

Using the formula above, we can determine the following inventory turnover periods:

2021: 23.01 days

2020: 21.94 days

(Note that the average inventories amount was calculated as the simple average of opening and closing inventories. For businesses with seasonal or other unusual patterns of sales, more sophisticated calculations of the average inventories may be required.)

In this example, the inventory turnover period increased by slightly more than one day during the current year. This may not seem significant, but it does indicate that inventories are being held for a longer time, which will increase the company’s costs. Line managers are very motivated to find ways to reduce the turnover period through more efficient purchasing practices, better production techniques, and more effective sales promotions.

It should be noted that the absolute values of the ratios we have calculated are not particularly useful on their own. Like all ratios, a comparison or benchmark is needed for comparison. Most companies will start by comparing the ratio with the previous year to see if improvements have occurred in the current year. Many managers will also compare with a budgeted or target amount, as this will provide feedback on the actions they have taken. It may also be useful to compare with industry standards or competitor data, as this indicates something of the company’s competitive position. Ratio analysis does not provide answers to questions, but it does help managers and other financial statement users to identify areas where performance is improving or declining.