The Crucial Balance Sheet Metric Everyone Ignores
When researching a company, there are dozens of line items to look at in the financial statements. And there are dozens more ways of interpreting, dissecting and analyzing them.
But there’s one figure that is often ignored by investors and analysts alike…
I’m talking about inventory turnover.
When I look at a company, I pay close attention to this important variable. Yet most analysts never mention it. They’re too caught up in the figures that get all the headlines: earnings… sales… maybe cash flow if they’re not too lazy.
Don’t get me wrong: Sales and growth are important. But if you’re really researching a company and comparing it to its peers, wouldn’t you want to know if it sells its wares twice as fast – or if it sells half as much – as its peers?
That’s why knowing the inventory turnover ratio is crucial when weighing a potential investment.
By the time you’ve finished reading, you’ll know how to calculate this metric for yourself, using figures from the company’s balance sheet.
I’ll also give you a real-life example of a time when comparing the inventory turnover of three stocks would have helped you avoid two losses… and score a double-digit return.
First, let’s define our terms.
Inventory is the value of the company’s products that are sitting on its shelves. It’s reported as a current asset on every balance sheet.
Inventory turnover is how many times a company sells through its inventory in a quarter or year.
The inventory turnover ratio is calculated by dividing the cost of goods sold (COGS) by the average inventory. (Some people use sales instead of cost of goods sold, but I prefer the latter as it’s more conservative.)
COGS ÷ Average Inventory
It requires a little math to calculate the average inventory number, but it’s easy math. Just some basic arithmetic.
To find the average inventory for a quarter, you take the inventory number on the balance sheet from the most recent quarter as well as the number from the previous report and average the two.
So, if a company had $11 million in inventory at the end of the latest quarter and $9 million at the end of the previous quarter, the average inventory for the quarter would be $10 million.
If the company’s cost of goods sold – which is found on the income statement, usually right below sales – was $30 million, you’d divide $30 million by $10 million and the result is 3.
That means the company turned over its inventory three times during the quarter.
But inventory turnover is an annualized number, so we have to multiply that quarterly number by four. Three times four is 12. So our company turns over its inventory 12 times per year – or once per month.
To calculate the number for the year, you could also take the inventory figures at the end of the current year and the figure for the previous year to get the average of the two.
That’s not so difficult, is it? If you have time, I recommend practicing on one of your current holdings.
As I said, knowing the inventory turnover ratio for companies in your portfolio – or a company you’re considering – can be very useful. Because even if a company’s sales and profits are strong, if it is not turning over its inventory quickly, that means it has too much capital tied up in product.
That capital could be better used to grow the company… or perhaps it should be returned to shareholders.
Plus, inventory that sits on the shelf too long can become outdated and may eventually have to be discounted.
On the flip side, a very high inventory turnover ratio could suggest that the company can’t meet demand and is missing out on sales. That’s where your analysis will come in.
As a general rule, you’d like to see your company have a higher inventory turnover ratio than its peers – but not so high that it suggests it can’t supply its customers.
Let’s look at an example…
Costco (Nasdaq: COST) reported results for fiscal first quarter 2016 (ending November 22) last month. Its COGS was $23.6 billion.
Inventory was $10.4 billion. But remember, we need the average for the quarter. So we also need to consider the number reported for the previous quarter. Back then, inventory stood at $8.9 billion.
So, average inventory = $9.7 billion.
Next we divide the $23.6 billion COGS by $9.7 billion for an inventory turnover of 2.4.
To get the annual figure, we multiply 2.4 by 4 and get 9.6.
That means Costco turns over its entire inventory 9.6 times per year.
Now let’s compare it to competitors like Wal-Mart (NYSE: WMT) and Target (NYSE: TGT).
You can see that Costco turns over its inventory faster than Wal-Mart and nearly doubles Target’s number.
Does that make Costco a better company? Not necessarily. There are lots of things to consider. But it does mean that Costco’s items sit on the shelf for shorter periods than its competitors. That’s a good thing.
And, for what it’s worth, over the past year, Costco’s shares have soared as high as 20% while Wal-Mart’s and Target’s have fallen 25% and 5%, respectively.
Inventory turnover gives me an insight into how efficient a company’s management is – and whether customers are buying what the company’s selling. That’s why it’s one of my favorite things to look at when comparing similar investments.
When inventory is turning over quickly, it’s an indication that the company could be able to get full price on its goods. When inventory is not moving, discounts and lower margins may be on the horizon.
This oft-ignored measure of a company’s business will take you beyond the headline numbers issued in press releases… and give you a deeper understanding of the companies you’re interested in.
P.S. I hope you find my tips above useful. Over the years, I’ve used the inventory turnover ratio to determine if countless stocks were worth my time – and that of my readers. As part of my proprietary investing algorithm, it’s helped paid subscribers Andrew S. and Robert A. close gains of 207% and 214%, respectively. But as impressive as those returns are, I see something even bigger coming around the bend… I’ll show you precisely what I mean in this short video.
About Marc Lichtenfeld
A master of the steady, reliable science of income investing, Marc’s commentary has appeared in The Wall Street Journal, Barron’s and U.S. News & World Report. He has also appeared on CNBC, Fox Business and Yahoo Finance. His book Get Rich With Dividends: A Proven System for Double-Digit Returns achieved best-seller status shortly after its release in 2012. He captures the hearts and minds of readers approaching their golden years in his daily e-letter, Wealthy Retirement.