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Inventory Impacts Bottom Line in Financial Analysis

4/12/16

Remember those days when you were counting inventory stock while everyone else was comparing golfing scores?

At the time, you probably asked the question, “Why am I doing this on a sunny Saturday?”Perhaps what you failed to notice was the relationship between an inventory count and the bottom line on your income statement. Financial analysts compare those bottom line scores just as your buddies compare their golfing scores.

Inventory’s impact on financial analysis is no trivial matter.

Example: During fiscal year 2001, Cisco had an excessive inventory charge of $2.8 billion. This was one of the largest inventory write-downs of parts for the once-booming Internet industry – or for any company.

Cisco and its computer models had miscalculated market demand. The dot.com implosion was sudden and dramatic, and the subsequent write-downs were a sobering reality on Cisco’s 2001 net income – to the tune of a $1 billion loss. This loss was in stark contrast to the previous year’s net income of $2.6 billion.

It should be noted that Cisco generated sales revenue and incurred service expenses in addition to product sales revenue and expenses, and the total net income amount listed reflects all source of revenues and expenses.

Key numbers from Cisco’s annual reports from its 1999-2001 10-Ks

  2001 2000 1999
Revenue from sales of product $19.6 billion $17.0 billion $11.1 billion
Cost of sales product $10.2 billion $6.0 billion $3.8 billion
Total net income ($1 billion) $2.6 billion $2 billion
Provision for inventory change $2.8 billion $339 million $151 million

Although the cost of sales as a percentage of revenue from sales reveals a sudden change, the underlying cause is not evident.

2001 2000 1999
52% 35% 34%

The provision for the inventory charge of $2.8 billion in 2001 as an add back to the net income amount provides a clue.

The charge against earnings did not require a cash expenditure at the time of the write-down. The financial statement footnotes provide the narrative to the story revealed in the accounting numbers.

Cisco adopted an accounting principle known as lower of “cost” or “market.” Companies are required to list inventory values at cost unless obsolescence, deterioration or market cause a decline in the values of those goods or parts. If the market value falls to zero, the charge is a write-off, while a write-down means the inventory has some value remaining.

The charge is usually included in the cost of goods sold and, thus, the increase in the Cisco’s 2001 cost of sales product in the amount of $10.2 billion. In this case, the inventory items were kept, not destroyed. These same items could be sold later at a profit if the selling price exceeded their adjusted decreased value.

Another interesting relationship is the number of days in inventory. For example, using the $6 billion cost of sales in 2000, and assuming ending inventory was $1.5 billion, this would mean Cisco had an inventory turnover ratio of four [$6/$1.5 = 4]. This would result in Cisco having 91 days in inventory [365 days/4]. However, increasing or decreasing the dollar amount of ending inventory would indeed impact these ratios.

Sometimes the inventory cost-flow assumption adopted by a company can lead to ratio distortions. Several assumptions are permitted, but the two principles adopted by most companies are first-in, first-out (FIFO) and last-in, first-out (LIFO).

Regardless of when the inventory was acquired, under FIFO the cost of goods sold is determined using the cost of the first goods acquired. Under LIFO, the cost of goods sold is determined using the cost of the last goods acquired.

Example: Two companies each acquired 500 units in June for $1,000 and another 500 units in July for $3,000. In August, each sold 500 units for $5,000.

Co. A has generated a net income that is double that of Co. B, yet both started out with the same sales number. The reason for the difference is the method of inventory valuation – Co. A used FIFO and Co. B used LIFO.

FIFO (Co. A)                                                         LIFO (Co. B) 

This result will appear during a period of rising prices (does gasoline come to mind?). Most fuel companies adopt a LIFO approach, and yet they still manage to generate large net incomes. For example, on Feb. 3, 2008, Mobil announced earnings for 2007 of $40.6 billion.

The current ratio, which is defined as current asset including inventory, divided by current liabilities, is a measure of liquidity of the company. The higher the ratio, the better the company’s liquidity. Suppose each company had $1,000 in liabilities, and assume the only current asset was ending inventory. The results would be:

Co. A $3,000/$1,000 = 3
Co. B $1,000/$1,000 = 1

Co. A appears to be more liquid than Co. B, but in actuality they both should be the same. This can make for a very difficult comparison when trying to compare FIFO versus LIFO firms. The Securities and Exchange Commission adopted a policy that requires firms adopting LIFO to disclose the dollar difference in values between FIFO and LIFO inventory costs. This difference is called the LIFO reserve.

These are just some of the issues when the inventory is correct.

What happens when your inventory score is incorrect?

Imagine what happens when you are in a golf tournament and you sign your score card with the incorrect score. Inventory cases abound where inventory counts have reported bogus values either through fraud or neglect, but that’s a mulligan for another day.