Companies have a choice as to how they value the inventory they keep. Had Fiji water bottled 4 million bottles of water at a buck each 2 years ago, before the drought...they then have the choice of carrying that inventory value at their book value of $4M...or they could carry them at today’s prices, or market prices, of $2.50 a bottle, or $10M.
So now think about the case where Ray Bans has spent a fortune stocking up on dark, sun-adjusting glass lenses for sunglasses at 50 bucks each, knowing that market prices for them are more like 20 bucks if they had to dump them all today.
The minute they buy the $50 glass lens unit and put it in inventory, they show a notional loss of $30 on that transaction.
Well, if they’ve stockpiled, say, 50 million dollars worth of glass lenses, which they’re holding as being worth 20 million today...but then don’t buy any more lenses for 6 months, letting inventory dwindle from a million units to just 100,000…what happens to their profit margins?
Well, from an accounting perspective, almost nothing. The company used up its stockpile of inventory that it had held at a static price all along. Nothing really changed. They sold their glasses for, say, $80 a unit, and from an accounting perspective, they made a notional $30 per unit, as they depleted inventory.
But what happened to their cash flow levels? If no cash is going out the door to restock inventory, wouldn’t you think cash flow would grow dramatically? Of course it would. The question: how do you account for this relatively sudden change?
Just for clarity’s sake, essentially what Ray Bans will have been doing here is plundering the mountain of sunglasses in those little cheap leather boxes you can never open properly, letting the mountain dwindle down to a molehill as they convert all of that value into cash, and then have no more mountain to go back to, should there be a massive, late-term run on demand for sunglasses from the unholy union of the Krakens and the Hydra.
So that’s inventory as a kind of storage shed of cash for a company…and it applies especially powerfully to products that have no shelf life. Meaning…a pair of dark sunglass lenses don’t go bad in 2 weeks the way a carton of eggs does.
In that case, inventory has a very finite value that decays the moment that inventory is stocked, or laid on the shelves, and companies then have to shell out an allocation for that decline in value.
Regardless, tracking the purchase price, or acquisition price, of that inventory is hugely important when you’re putting together the forensics of a company’s reported earnings...and marking the period-to-period change in that inventory as a driver of cash balances is big as well. Meaning that it’s an awfully low quality cash flow or cash earnings quarter when a company simply grew cash flow because they brought down their inventory from $50 million to $10 million. At some point soon, that well runs dry.
Related or Semi-related Video
Finance: What is Inventory Turnover?2 Views
Finance allah shmoop What is inventory turnover All right well
this is inventory and this is a turnover Okay so
what is it really Well you have inventory I'ii stuff
you want to sell and then you sell it You
started the year with a thousand edible necklaces The pumpkin
spice model promises to be very popular anyway You sold
them for ten dollars each So you have ten grand
in inventory But you did five hundred eighty thousand units
of sales inventory turnover Big Really big five hundred eighty
times big Okay different story Your tesla You have one
hundred tires in inventory You had that same number january
one in april twelfth In july twenty third and december
Thirty one of this year One hundred tires steady state
But you sold fifteen thousand cars in a year We'll
let four tires apiece Yeah That's a sixty thousand tires
And we're not counting that thing in the trunk It's
Not really a tyre anyway It's More like a bicycle
tire Enormous inventory turnover Sixty thousand over one hundred or
six hundred Ex enormous inventory turnover Very efficient use with
the capital spent on those hundred tires Well so why
Does inventory turnover even matter Alright Yeah it's about capital
We hinted you there Think about your capital needs Like
if you have to raise tons of money to store
tons of inventory that you take forever to sell Well
then you're not using your capital very efficiently Like why
not make the tire manufacturers who are actually in the
business of building distributing and planning for tyre demand Why
not make them hold all the inventory using their capital
not yours Well not all inventory turnover numbers mean the
same thing like what's inventory in an oil rig leasing
company Well you keep eight rigs on hand you know
you'll have to tow them out to the middle of
the ocean At some point they're crazy expensive to build
and maintain and some years when oil is really cheap
there just won't be any demand for your rigs for
drilling so you'll have to store him and oil them
and wave to them kindly So how do you make
sense out of that number like oil rig Turn over
when you're comparing it to say a grocery stores turnover
where the average six pack of diet coke last like
fifty three hours on the shelves made so inventory turnover
is really more of a quote relative to last year
unquote thing or a quote relative to our hated competitors
bob unquote kind of thing And there are ways to
game this data point as well the easiest of which
is well too Just let your inventory amount fall like
if you started the year with a thousand naked cupid
hood ornaments and let supplies dwindled to just two hundred
while then via industry norms of just taking the average
quarterly inventory levels through the year Well you might show
an average inventory of six hundred units this year thereabouts
and you'd be going into the next year with only
two hundred and generated a lot of cash along the
way Like you turned all that money that was tied
up in your inventory in the cash on your bottom
lines that good Is it bad Well just like pretty
much everything in from of finance videos and diapers it
depends Well it's good to have low inventory to a
point What happens if you run so low that customers
can't buy from you because you can't fill orders for
three months and then they go to bob than the
cost of not having enough inventory was massive You lost
sales profits and market share or power or theft and
it hurt your brand like people don't respect it as
much anymore Yeah sorry just keeping it real But in
general high turnover is good It means you're using your
inventory capital of the capital you spent to build your
inventory efficiently and that when you make it to the
top of the hill you're you know able to keep 00:03:43.925 --> [endTime] your balance Yeah
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