We penalise companies with a high and rising level of finished goods relative to total inventories. There are a number of reasons to be concerned about an unusually large and rising exposure to finished goods:
- Obsolete inventory and future impairments: Most products have a limited life-span and decline in value over time. Persistently large inventories of finished goods might represent unsold and outdated products which should be written-off. Alternatively, large inventories could reflect inefficient management of the manufacturing process. In some instances, large inventories reflect management’s abuse of the last-in and first-out accounting treatment. In a situation where raw material input prices are falling, management might prefer to use newer raw materials which are priced lower than older raw materials. This will inflate profits but is reflected in rising inventories which will eventually have to be written-down.
- Deteriorating future profitability: Rising levels of inventory could simply reflect a company which is ramping up a new production line. If this is the case, it should be a temporary phenomenon. Alternatively, rising inventories might reflect deteriorating margins, thereby reducing the numerator relative to the denominator. More commonly, rising inventories reflect increasing input costs which will translate into falling future margins and lower profitability.
We would expect some businesses to have a high level of finished goods relative to total inventories, such as retailers, as shown in Figure 21. However, manufacturing companies are likely to have substantial amounts of raw materials involved in the manufacturing process. As such, there is considerable variation by industry.
Under our accounting screen a red flag is triggered when finished goods/inventory is above the 80th relative to industry peers (i.e. it is either very high). Red flags are also triggered when inventory/sales changes at an unusually large rate over 1 and 3 years. This latter red flag is triggered when the increase in in the 80th percentile relative to the change experienced by industry peers between 2010 and 2015.