Financial statements analyses which fail to consider the impact of differences in methodologies adopted, disclosures made, and presentation formats are likely to result in faulty conclusions.
An analyst has to have a critical mind and give consideration to the information at his/her disposal which supports the financial statements that have been presented. Information on a company’s inventory disclosures is no exception.
Considerations Relating to Inventory Disclosures
It is crucial that analysts recognize that a company’s choice of inventory valuation method can have a significant impact on the presentation of its financial statements. Therefore, financial items such as cost of sales, gross profit, net income, inventories, current assets, and total assets will be impacted.
The financial ratios which contain these items, such as the current ratio, return on assets, gross profit margin, and inventory turnover, will also be impacted. The current ratio is impacted owing to the fact that inventory is a component of current assets, while the return on assets ratio is impacted because cost of sales is a key component in deriving net income and inventory is a component of total assets.
The financial statement items and financial ratios may also be impacted by adjustments of inventory carrying amounts to net realizable value or current replacement cost.
Analysts must therefore carefully consider inventory valuation method differences when evaluating a company’s financial performance over time, and especially when comparing its performance with the performance of its peers or industry as a whole.
To better use the inventory disclosure information, an analyst needs to get a better understanding of:
- The right size for the company’s inventory;
- The percentage change of the categories composing the inventory;
- The growth rate of inventory compared to the growth rate of sales; and
- Other sources of information.
If a company’s inventory is too small, it might miss selling opportunities. If a company invests too much in its inventory, it would negatively affect most of the financial ratios. To figure out whether a company’s inventory has the right size or not, an analyst needs to compare the company’s inventory turnover ratio with the trend of the company’s sales.
Inventory Composing Category
The percentage change of categories composing the inventory could be a signal of a company’s management expectations about future demand on the company’s products. The percentage increase of “finished goods” and “work-in-progress” indicates an expectation of high demand for a company’s products. On the other hand, if “finished goods” increase – in terms of percentage – it might indicate a slower growth of sales in the future.
Inventory Growth Rate Relative to Sales
An analyst needs to compare the growth rate of a company’s “finished goods” and the growth rate of its sales. If they move in tandem, it could be an indicator of steady sales growth trends. If they diverge, it might be an indicator that the sales growth rate would either reverse or slow down.
Other Sources of Information
Analysts should also give consideration to additional information about a company’s inventory and its future sales which may be found in other sources such as the Management, Discussion, and Analysis (MD&A) or similar sections of the company’s financial reports, industry-related news and publications, and industry economic data.
Which of the following financial statement items is not directly affected by the choice of inventory valuation method?
A. Net income
B. Cost of sales
The correct answer is C.
Revenue is not affected by the choice of inventory valuation method. Net income and cost of sales, on the other hand, are.
After analyzing the latest financial reports of Yeez Company, an analyst noticed that the ratio of “finished goods” to overall inventory is decreasing and the ratio of “finished goods” to sales is also decreasing. An analyst would most likely conclude that:
A. The sales trend is rising.
B. The sales trend is declining.
C. The information is not sufficient to make any conclusion.
The correct answer is B.
The percentage decrease of “finished goods” as an inventory component suggests that the company’s management expects a slowdown in sales. The decrease of “finished goods” to sales confirms the previous conclusion.
Reading 25 LOS 25j:
Explain issues that analysts should consider when examining a company’s inventory disclosures and other sources of information