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.
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Finance: What is inventory?2 Views
Finance allah shmoop What is inventory Well it's Just stuff
you have for sale in one form or another An
auto dealer Well all those cars she has sitting out
there in the sun is a dive bombing targets for
the birds Yeah while their inventory to the car dealership
the cars are inventory the loads of nose hair trimmers
sitting on the shelves at the well appointed nostril fine
store best nostril trimming store in the world Yet their
inventory albeit kind of gross ish inventory especially after use
the four thousand yards of denim cloth sitting in the
weaving factory waiting for thirteen year old girls in thailand
toe weave it all together to make levi's for the
gap Yep that cloth is inventory It isn't finished inventory
It's just a work in process not yet ready for
prime time or a prime thigh or whatever But it's
an asset for the company who owns it and it
is held as inventory on the balance sheet Work in
process right there at the balance sheet right there Okay
And when that inventory is sold and turned into revenues
it'll just become part of the expenses line on the
income statement usually has cost of goods sold or caw
Gse that's What people in the accounting bids say Cocks
thie Inventory is a good but inventory is always good
Of course as many a customer has learned after taking
a hefty shock straight to the hunger And that hurts
Up Next
Inventory turnover...way less delicious than an apple turnover. So...what is it?
Work-in-process inventory is just inventory... that is in the process of being built. In other words, it accounts for the inventory's asset value.
How is inventory managed for cash flow purposes? In order to avoid the cost of carrying slow moving or out of favor inventory that would take space...