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Diversity Investment GroupTaking Inventory:The Relationship Between Sales, Receivables and Inventory |
BetterInvesting Magazine, July 2006
by
Avi Horwitz
The Stock Selection Guide, the main
stock-study tool of the BetterInvesting community, helps us determine whether a
company is of sufficient quality to warrant our attention and whether it's
selling at a reasonable price. It has been said that 80 percent of what we need
to know is on the SSG. This month we'll look at one of the issues that may
sometimes be part of that other 20 percent.
When we begin to look at annual reports and financial statements, one of the earliest discoveries we might make is that we can compare the company's growth rates for sales, accounts receivable and inventory (for those companies that maintain an inventory).
When accounts receivable -- money owed for products and services supplied to customers -- are growing at a substantially faster rate than sales, it could indicate the company is concentrating on moving goods out of inventory and increasing sales. One way this can happen is by the company easing credit requirements for purchasers. This could have disastrous effects if customers later are unable to pay for the purchases.
Accounts receivable also can outpace sales when a company engages in hard-sell tactics to move goods from inventory and create sales. This often is done by encouraging customers to purchase more goods than they really need. Unfortunately, this often causes purchasers to buy products they would have bought later and in reality just cannibalizes future sales.
When beginning to focus on these issues, we can compare the growth in inventory with sales growth. If inventory is growing substantially faster than sales, it could indicate the company is ramping up for an expected increase in demand. Unfortunately, it could also mean the company is stuck with goods that aren't selling.
In this situation, looking at what's happening within the inventory itself can be quite useful. This is particularly true for companies with products that are prone to obsolescence, such as technology products or perishable food items.
For companies that manufacture products, rather than just buy goods to resell, inventory doesn't consist solely of finished goods ready to be sold. Part of a manufacturing company's inventory is raw materials, the items needed to assemble the final product. These companies also generally have work in process -- partially assembled products. Sometimes raw materials and work in process are lumped together in financial reports and referred to as "other" to distinguish them from finished goods.
When enough information is provided, it's often helpful to dig a little deeper and look at the growth rates of inventory components. We have developed a spreadsheet to help calculate the percentage change in sales, receivables, total inventory and the components of inventory.
An example is above. Note that in this spreadsheet for Lucent, there's no information in the raw materials column. This is because Lucent's financial reports lump raw materials with work in process and refer to them as "other." (If you would like the Excel spreadsheet, e-mail me at avi.horwitz@niaboard.org. Those attending the convention will receive the spreadsheet on the handout CD.)
Using Lucent as an example -- in hindsight -- we can see when the price began to tumble downhill. As indicated in the stock price graph on page 84, we had the opportunity to see the potential price downturn a full 12 months before the price really began tumbling.
If we graph some of the data we detailed in the spreadsheet, we can see some interesting things happening (see graphs below). In one graph, we plotted the trailing 12-month growth for sales, receivables and total inventory. The graph shows that for at least the last three quarters of 1999, receivables were climbing faster than sales, and inventory was climbing even faster than receivables.
Lessons After the Fall: Hindsight is always 20/20, but the decline in Lucent's stock price began at about the same time inventory problems became obvious.
Lucent provides a breakdown of its inventory into finished goods and other (combining raw materials and work in process). Receivables and inventory are growing faster than sales, so we plotted the receivables and inventory components, showing the trailing 12 months' growth.
An interesting pattern emerges. It becomes rather apparent that finished-goods inventory grew much more rapidly than anything else. This leads us to conclude the company's products weren't exactly flying out of warehouses.
When this happens a company generally will incur more costs to store the inventory. Also, when the product is technology-dependent, the longer the product sits in the company warehouse, the more likely it is to become obsolete.
We also can see that other inventory (raw materials and work in process) wasn't growing as quickly, which leads us to believe they weren't ramping up to increase production. Obviously, people weren't lining up to buy Lucent's products. With this information and the drop in sales growth in the last quarter of 1999, we should have seen a price drop coming.
The table above details the price history and highlights the periods in which financial information became available. As you can see, several quarters of information became available that helped establish a pretty clear pattern. We were able to see the problems over a full year before the stock price rapidly dropped.
If you have questions or comments, write to: DIGnet@mindspring.com.
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07/01/2006