Financial Statement Analysis: Analysing Inventory and Accounts Receivables

Key takeaways

1) Why an abnormally large inventory or accounts receivable is a potential red flag.

2) Why is it crucial to monitor to monitor both inventory and accounts receivable alongside a company’s revenue.

There is a very simple way to spot red flags in companies. This is by analysing their inventory and accounts receivable alongside their revenue numbers. This step is very crucial, especially when dealing with high tech manufacturing or any other consumer sensitive industries where inventory goes obsolete very quickly due to rapid market changes. Rapid rising inventory and/or accounts receivable with respect to revenue indicates a warning sigh. More investigation into its causes will be needed. Before we proceed, let us review some of the basic fundamentals of each balance sheet item.

Accounts Receivable

Accounts receivable is mostly a current asset item on the balance sheet and is defined as cash due from customers as goods/ services have been performed or rendered. For instance, if I were a fish farm owner, I may allow certain trustworthy and/or credit worthy customers to purchase my fish on credit. I would give them x amount of days/months/years to pay me.

The warning sign comes when accounts receivable starts to rise substantially over a period of time. There are many possible interpretations to this. It could mean that the company may be desperately trying to clear its inventory by using hard sell tactics or allowing liberal credit terms. Such practices are very common in industries where inventory goes obsolete very quickly due to rapid market changes. In bad economic times, accounts receivable write downs may occur and revenue will be affected. Therefore, it is crucial to understand how a company manages its inventory and how credit worthy their clients are.

Inventory

Unlike service companies, manufacturing or retail companies need to stockpile their inventory. Therefore, understanding a furniture company’s inventory will be much for useful than understanding the inventory of a biomedical drug company. This is especially crucial in industries such as retail, semiconductor or the consumer electronics industry where inventory goes obsolete very quickly due to rapid market changes. Large inventory write downs may happen if inventory is not properly managed by the management.

Under inventory, it is very important to individually analyse the different segments of inventory under the annual report’s footnotes. If one were to discover that the finished goods segment of inventories is rising more rapidly than raw materials and/or work in progress, it is likely that the company has an abundance of finished goods and may be anticipating a certain type of demand for its goods. In most cases, if finished goods segment is rising more rapidly than raw materials and/or work in progress, the company will have to slow down its production. This is because bulging inventories are costly. There is a term used to describe this situation. It is known as negative inventory component divergence. [1]

However, if one discovers that the company’s raw materials is advancing much more rapidly than the work in process and finished good components, it is likely that the company is receiving many new orders and therefore an inventory build-up is necessary. This term is described as positive inventory component divergence. [1]

Connecting the various pieces

As mentioned above, when dealing with consumer sensitive retail or high tech manufacturing companies, it is crucial to correlate its revenue with its accounts receivable and inventory.

For instance, a company may be anticipating more demand in its products due to constant rising demand and revenues over the past few years. It may start to produce more goods in anticipation. When inventory rises and becomes much greater than revenue, it may result in unsold inventory or liberal credit terms to clear out the remaining products. In a market where products becomes obsolete very quickly, it may result in inventory or accounts receivable write-downs.

This concept coupled with a good understanding of the company’s products and expansion policies can definitely help prevent future investment losses and help in the forecast of a company’s future earnings. When it comes to analysing financial statements, the devil is always in the details.

References

[1] L.O’Glove, T. (1987). Quality of Earnings. 1st ed. The Free Press, pp.106-125.

 

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