Differences in inventory valuation methods and inventory write-downs and reversal affect financial statements and financial ratios. Disclosures required by accounting standards are useful in adjustment of financial statements for comparison between companies.
Disclosure requirements related to inventories
IFRS requires companies to disclose their inventory accounting policies and cost formulas, a breakup of total carrying amount of inventories, a breakup of inventories carried at fair value less cost to sell, cost of sales, amount of any write-down, the amount of any reversal, an explanation of the circumstances of why the reversal was made and carrying amount of any inventories pledged as security. US GAAP requires similar disclosures (except for the amount of reversal and associated explanation), plus disclosure of significant estimates, and of any material effects of LIFO liquidation.
Inventory ratios
Ratios such as inventory turnover (calculated as the cost of sales divided by average inventories), days of inventory on hand (which equals 1 divided by inventory turnover), and gross profit margin are useful in analysis of a company’s inventory management. A company’s inventory valuation method and policies affect these ratios directly and certain other ratios, such as current ratio, return on assets, debt to equity, etc. less directly.
High inventory turnover and low days of inventory on hand might indicate effective inventory management (particularly when sales growth is good). However, the ratios must be compared with industry and across time for the same company to make sure that it is indeed the case. Because a high turnover ratio may result from low inventory balance (inventory shortage) or inventory write-downs. Low inventory turnover and high days inventories on hand generally indicate slow-moving or obsolete inventories. The gross profit of a company is often a function of its industry and competitive strategy. Gross profit in competitive industries is lower.
Analysis of inventories can provide useful insight into a company’s outlook. For example, an increase in the volume of raw materials inventory may signal that the company is expecting an increase in demand. It is useful to compare growth in sales to growth in finished goods inventories. A build-up of finished goods inventory (coupled with a decline in raw materials and work-in-progress) may suggest that the company is facing reduced demand and hence its inventories are piling up (and may result in potential write-down). Lastly, the analysis should be in the context of the industry’s general trend of technological changes and seasonality.