Chapter 15

Turning Up Clues in Turnover and Assets

In This Chapter

Comparing inventory valuation systems

Counting inventory turnover

Measuring fixed assets turnover

Assessing total asset turnover

Testing how well a company manages its assets is a critical step in measuring how effectively it uses its resources. Inventory is the most important asset for generating cash for any company that sells a product.

Many factors directly impact the cost of selling a product, including producing the product, purchasing the products or materials not produced in-house, storing the product until it's sold, and shipping the product to the customer or store where it's sold. And if a company doesn't sell its product fast enough, the product may become obsolete or damaged before it's sold.

In this chapter, I review the measures you can use to gauge how well a company manages its assets, especially its inventory, and how quickly the company sells the inventory.

Exploring Inventory Valuation Methods

A company must know the value of its inventory to complete its balance sheet. In addition, the company must set a value for the items it sells in order to include a cost of goods sold number on its income statement (see Chapter 7). How that value is calculated depends on the accounting method the company uses. Five different methods are acceptable for determining the value of inventory, and each one can result in a different net income. These methods include the following:

• Last in, first out (LIFO) inventory system: This system assumes that the last item put onto the shelf is the first item sold. Each time a product is purchased or manufactured to be put on the shelves, it costs a different amount. Most times, the cost goes up, so the last item put on the shelf likely costs more than the first item. Therefore, the goods sold first in the LIFO system are the highest-priced goods, which raises the cost of goods sold number and lowers the net income. Stocking a shelf by leaving the older items in place and just adding the newly received products in front of them is a lot quicker. For example, hardware stores often use this method when restocking products that rarely change, like hammers and wrenches. Be aware that a company must use the same method for all its inventory.
• First in, first out (FIFO) inventory system: This system assumes that the first item put on the shelf is the first item sold. Just as for LIFO, the cost of goods purchased or manufactured differs each time they're bought or made. Usually, prices increase, so in the case of FIFO, the first item put on the shelf likely has a lower cost than the last item. Because the first item is the one sold first, the cost of goods sold will likely be lower than for a company that uses the LIFO method. Therefore, the cost of goods sold number will be lower and the net income will be higher. For example, grocery stores must worry about spoilage, so they put the newly received products behind the older ones to be sure that the older products sell first, before they spoil.
• Average costing inventory system: This system doesn't try to specify which items sell first or last, but instead calculates the average cost of each unit sold. This method gives a company the best picture of its inventory cost trends because the ups and downs of prices don't impact the company's inventory. Instead, the inventory value levels out through the year. The net income actually falls somewhere between the net income figures based on LIFO and FIFO.
• Specific identification inventory system: This system tracks the value of each individual product in a company's inventory. For example, car dealers track the value of each car in their stock by using this method. The net income is calculated by subtracting the cost of goods sold that have been specifically identified from the price at which the items are sold.
• Lower of cost or market inventory system: This system sets an inventory value based on whichever cost is lower: the actual cost of inventory or its current market value. Companies whose inventory values can change numerous times, even throughout a day, most often use this valuation method. For example, dealers in precious metals, commodities, and publicly traded securities commonly use this system.

In most cases, companies use the LIFO, FIFO, or average costing inventory system. Specific identification inventory comes into play only with companies that sell major items that each have a unique set of add-ons, such as cars or high-end computers. Therefore, each product has a different cost of goods sold value. The lower of cost or market inventory system primarily applies to companies that sell marketable securities and precious metals.

The way a company values its inventory has a major impact on its bottom line. The reason is that the figure a company uses on its income statement for cost of goods sold depends on the costs it assigns to the inventory it sold during the period that income statement covers. The inventory's value shown on the balance sheet is what's left over and still held by the company, so the ending inventory's value is the value of the goods the company still holds. This is listed as a current asset on the balance sheet.

If you're a company outsider, you won't be able to get the details you need to calculate the value of the products left in inventory. In fact, many times, only the company insiders directly involved in inventory decision making have access to cost details. Many companies consider actual inventory costs to be a trade secret, and they don't want their competitors to know the details. Nonetheless, understanding what's behind those numbers and how different inventory methods can impact the bottom line is important for understanding financial reports.

If you're comparing two companies that use two different methods, you need to take that factor into consideration when doing the comparisons. You can find out in the notes to the financial statements which method a company uses.

To calculate a company's cost of goods sold, you must know the value assigned to the beginning inventory (which is the same as the ending inventory for the previous period and is also the same as the inventory number you find on the balance sheet). The beginning inventory is the number that's used at the beginning of the next accounting period, so any purchases made during this period are added onto the beginning inventory. Finally, you need to number how much inventory is left at the end of the accounting period, which is called the ending inventory. Using those figures, here's the formula for calculating the cost of goods sold:

1. Find the value of the goods available for sale.

   • Beginning inventory + Purchases = Goods available for sale

2. Calculate the value of items sold.

   • Goods available for sale – Ending inventory = Value of items sold

Applying Three Inventory Valuation Methods

To give you an idea of how inventory can impact the bottom line, the following sections use an inventory scenario to take you through the calculations for cost-of-goods value by using the three key methods: average costing, FIFO, and LIFO.

In all three cases, I use the same beginning inventory, purchases, and ending inventory for a one-month accounting period in March.

1. 100 (Beginning inventory) + 500 (Purchases) = 600 (Goods available for sale)
2. 600 (Goods available for sale) – 100 (Ending inventory) = 500 (Items sold)

Three inventory purchases were made during the month:

The beginning inventory value was 100 items at $9 each.

Average costing

Before you can use the average costing inventory system, you need to calculate the average cost per unit.

Plus purchases:

• Cost of goods available for sale = $6,500

Average cost per unit:

• $6,500 (Cost of goods available for sale) ÷ 600 (Number of units)  = $10.83 (Average cost per unit)

When you know the average cost per unit, you can calculate the cost of goods sold and the ending inventory value pretty easily by using the average costing inventory system:

So the value of cost of goods sold using the average costing method is $5,415. This figure is the one you see as the Cost of goods sold line item on the income statement. The value of the inventory left on hand, or the ending inventory, is $1,083. This number is the one you see as the inventory item on the balance sheet.

FIFO

To calculate FIFO, you don't average costs. Instead, you look at the costs of the first units the company sold. With FIFO, the first units sold are the first units put on the shelves. Therefore, beginning inventory is sold first, then the first set of purchases, then the next set of purchases, and so on.

To find the cost of goods sold, add the beginning inventory to the purchases made during the reporting period. The remaining 100 units at $12 are the value of ending inventory. Here's the calculation:

In this example, the cost of goods sold includes the value of the beginning inventory plus the purchases on March 1 and 15 and part of the purchase on March 25. The units that remain on the shelf are from the last purchase on March 25. The cost of goods sold is $5,300, and the value of the inventory on hand, or the ending inventory, is $1,200.

LIFO

To calculate LIFO, start with the last units purchased and work backward to compute the cost of goods sold. The first 100 units at $9 in the beginning inventory end up being the same 100 at $9 for the ending inventory. Here's the calculation:

So the Cost of goods sold line item that you find on the income statement is $5,600, and the Value of the inventory line item on the balance sheet is $900.

How to compare inventory methods and financial statements

Looking at the results of each method side by side shows you the impact that the inventory valuation system has on the net income statement:

LIFO gives the lowest net income figure and the highest cost of goods sold. Companies that use the LIFO system have higher costs to write off on their taxes, so they pay less in income taxes. FIFO gives companies the lowest cost of goods sold and the highest net income, so companies that use this method know that their bottom line looks better to investors.

Results for the inventory number on the balance sheet also differ using these methods:

LIFO users are likely to show the lowest inventory balance because their numbers are based on the oldest purchases, which, in many industries, cost the least. This situation is exactly opposite if you look at an industry in which the cost of goods is dropping in price — then the oldest goods can be the most expensive. For example, computer companies carrying older, outdated equipment can have more expensive units sitting on the shelves if they try to use the LIFO method, even though the units may not be worth anywhere near what the company paid for them.

Determining Inventory Turnover

The big question you have for any company is how quickly it sells its inventory and turns a profit. As long as a company turns over its inventory quickly, you probably won't find outdated products sitting on the shelves. But if the company's inventory moves slowly, you're more likely to find a problem in the valuation of its inventory.

You use a three-step process to find out how quickly product is moving out the door.

Calculating inventory turnover

Here's the three-step formula for calculating a company's inventory turnover:

1. Calculate the average inventory (the average number of units held in inventory).

   • Beginning inventory + Ending inventory ÷ 2 = Average inventory

2. Calculate the inventory turnover (the number of times inventory is completely sold out during the accounting period).

   • Cost of goods sold ÷ Average inventory = Inventory turnover

3. Calculate the number of days it takes for products to go through the inventory system, according to the accounting policies in the notes to the financial statements.

   • 365 ÷ Inventory turnover = Number of days to sell all inventory

In this calculation, you find out the number of days it takes the company to sell its entire inventory.

I use Mattel's and Hasbro's 2012 income statements and balance sheets to show you how to calculate inventory turnover and the number of days it takes to sell that inventory. Both companies use the FIFO inventory system to value their inventory, according to the accounting policy in their notes to the financial statements.

Mattel

1. Find the average inventory.

   Use the inventory on hand December 31, 2011, as the beginning inventory, and use the inventory remaining on December 21, 2012, as the ending inventory.

   • $487,000,000 (Beginning inventory) + $465,057,000 (Ending  inventory) ÷ 2 = $476,028,500 (Average inventory)

2. Calculate the inventory turnover.

   You need the cost of goods sold figure on the 2012 income statement to calculate the inventory turnover.

   • $3,011,684,000 (Cost of goods sold) ÷ $476,028,500 (Average  inventory) = 6.33 (Inventory turnover)

   This figure means that Mattel completely sold out its inventory 6.33 times during 2007.

3. Find the number of days it took for Mattel to sell out all its inventory.

   • 365 (Days) ÷ 6.33 (Inventory turnover) = 57.7

As an investor reading this report, you can assume that, on average, Mattel sells all inventory on hand every 57.7 days. Remember, though, that isn't true for every toy that Mattel makes. Popular toys may sell out, and new stock may be needed every month, whereas less popular toys may sit on the shelf for several months or more. This calculation gives you an average for all types of toys sold.

Hasbro

1. Calculate the average inventory.

   Use the inventory on hand December 31, 2011, as the beginning inventory, and use the inventory remaining on December 21, 2012, as the ending inventory.

   • $333,993,000 (Beginning inventory) + $316,049,000 (Ending  inventory) ÷ 2 = $325,021,000 (Average inventory)

2. Calculate the inventory turnover.

   To do so, use the cost of goods sold number on the 2012 income statement.

   • $1,671,980,000 (Cost of goods sold) ÷ $325,021,000 (Average  inventory) = 5.14 (Inventory turnover)

3. Find the number of days it took for Hasbro to sell off its inventory.

   • 365 (Days) ÷ 5.14 (Inventory turnover) = 70.95

So Hasbro sells its entire inventory every 71 days. Mattel is selling its toys faster.

What do the numbers mean?

Hasbro takes more than 71 days to sell all its inventory, and Mattel sells out every 57.7 days. Mattel turns over its inventory about six times a year, whereas Hasbro turns it over about five times per year. To judge how well both companies are doing, check the averages for the industry — you can do so online at Bizstats (http://bizstats.com/). Start by clicking on the selection for industry financial benchmark reports. Input the annual sales number. Using the stats for Miscellaneous Manufacturing, I find that 6.84 is the average inventory turnover ratio in the industry. So Mattel is slightly below average, at 6.33, and Hasbro, at only 5.14, has more room for improvement.

If the company you're evaluating has a slower than average inventory turnover, look for explanations in the management's discussion and analysis and the notes to the financial statements to find out why the company is performing worse than its competitors. If the rate is higher, look for explanations for that as well; don't get too excited until you know the reason. The better numbers may be because of a one-time inventory change.

Investigating Fixed Assets Turnover

Next, you want to test how efficiently a company uses its fixed assets to generate sales, a ratio known as the fixed assets turnover. Fixed assets are assets that a company holds for business use for more than one year and that aren't likely to be converted to cash anytime soon. Fixed assets include items such as buildings, land, manufacturing plants, equipment, and furnishings. Using the fixed assets turnover ratio, you can determine how much per dollar of sales is tied up in buying and maintaining these long-term assets versus how much is tied up in assets that are more quickly used up.

If the economy goes sour and sales drop, reducing variable costs is much easier than reducing costs for maintaining fixed assets. The higher the fixed assets turnover ratio, the more nimble a company can be when responding to economic slowdowns.

Calculating fixed assets turnover

Here's the fixed assets turnover ratio formula:

• Net sales ÷ Net fixed assets = Fixed assets turnover ratio

I show you how to calculate this ratio by using the net sales figures from Mattel's and Hasbro's income statements and the fixed assets figures from their balance sheets. For both companies, use the line item Property, plant, and equipment, net. (If a company doesn't calculate its fixed assets for you, you have to add several line items together, such as Buildings, tools, and equipment.)

Mattel

• $6,420,881,000 (Net sales) ÷ $4,088,983,000 (Net fixed assets)  = 10.82 (Fixed assets turnover ratio)

Hasbro

• $4,088,983,000 (Net sales) ÷ $230,414,000 (Net fixed assets) = 17.75 (Fixed  assets turnover ratio)

What do the numbers mean?

A higher fixed assets turnover ratio usually means that a company has less money tied up in fixed assets for each dollar of sales revenue that it generates. If the ratio is declining, it can mean that the company is overinvested in fixed assets, such as plants and equipment. To improve the ratio, the company may need to close some of its plants and/or sell equipment it no longer needs.

You can tell whether a company's fixed assets turnover ratio is increasing or decreasing by calculating the ratio for several years and comparing the results. The balance sheet includes two years’ worth of data, so in this example, you may be able to find the financial statements for 2010 online (if not, you can request them). Then you'd have the data for 2012 and 2011 on the 2012 balance sheet, and you'd have the data for 2010 and 2009 on the 2010 balance sheet.

Tracking Total Asset Turnover

Finally, you can look at how well a company manages its assets overall by calculating its total asset turnover. Instead of just looking at inventories or fixed assets, the total asset turnover measures how efficiently a company uses all its assets.

Calculating total asset turnover

Here's the formula for calculating total asset turnover:

• Net sales ÷ Total assets = Total asset turnover

I use information from Mattel's and Hasbro's income statements and balance sheets to show you how to calculate total asset turnover. You can find the net sales at the top of the income statement and the total assets at the bottom of the assets section on the balance sheet. Here are the calculations:

Mattel

• $6,420,881,000 (Net sales) ÷ $6,526,785,000 (Total assets) = 0.98 (Total  asset turnover)

Hasbro

• $4,088,983,000 (Net sales) ÷ $3,237,063,000 (Total assets) = 0.95 (Total  asset turnover)

What do the numbers mean?

Mattel and Hasbro have similar asset ratios, so their efficiency in using their total assets to generate revenue is about equal. Both companies hold more than half their assets in current assets, which means that they're relatively liquid and can respond quickly to industry changes.

A higher asset turnover ratio means that a company is likely to have a higher return on its assets, which some investors believe can compensate if the company has a low profit ratio. By compensate, I mean that the higher return on assets could mean increased valuation for the company and, therefore, a higher stock price.

In addition to looking at this ratio, when determining stock value, you need to calculate the profit ratios and return on assets. (I show you how to calculate these in Chapter 11.) Aside from inventory turnover, another key asset to consider is accounts receivable turnover, which I discuss in Chapter 16.