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Inventory - focus on the profit margins
Inventories are those items that companies purchase
or produce, for the express purpose of selling to customers for a profit. I
have found over the years that, most investors think of inventory with a
banker’s view, not a stockholder’s. People are generally skeptical of
inventory values. Everyone has a story of buying something at 10% of its
value. These experiences have caused many investors to develop homemade
“haircut” percentages that they apply to inventory balances, to try to
understand what the liquidating value might be, if the company’s inventory
was sold under distress conditions. This is a banker’s mentality on how to
collect debt. Investors need to think like owners to make money in the stock
market, not like bankers.
When buying common stock, investors usually pay for
earnings and profitability margins and percentages. When evaluating
inventories, investors need to be concerned with those same parameters.
Beginning and ending inventories must be properly valued in order for gross
profit margins to be correct. The profit margins ultimately determine
earnings, price earning ratios and share price. If the profit margins
change, then the valuation of the business also changes. While inventory
dollar values are important, the associated effect on historical and
prospective gross margin has a greater impact on one’s investment.
A write
down of inventory will definitely reduce the current year’s earnings and
equity, but one needs to understand what happened and focus on the recurring
effect on margins.
Click here for information on:
-Perpetual vs. Periodic Inventory
-Inventory Accounting Calculation
-Inventory Costing Methods
-Lower of Cost or Market Rules
-Inventory Categories
-Inventory Turnover Ratio
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