Business Tips: Inventories And Stock Values

Unsuspecting investors can get hosed by artificially bloated profits imploding under inventory. Explains why inventory growth is bad news.

Suppose you decide to start a small manufacturing business out of your garage. The idea is for you to make stuff and sell it for profit on eBay, so you sink a few thousand into equipment, get raw materials and start putting in the sweat equity. Soon you have an inventory, and all that remains is to sell them. Now, in this scenario, common sense tells us that you're in the hole until you've sold enough goods to pay for the equipment and the raw material, at the very least. If people buy your product, you make a profit off each unit and everything is peachy. If they don't, you eventually decide to cut your losses and close shop. Simple enough.

However, when this seemingly simple context is transplanted to large, publicly traded companies, the rules change somewhat. When they produce their quarterly reports, there are plenty of products halfway done and plenty of products waiting to be shipped to customers. For example, take a car manufacturer who has 500 cars currently on their way to dealerships. It would be unfair to claim that it had to take all the manufacturing costs into account, but since the cars technically was still part of the inventory, the company would get no credit for what is obviously perfectly sellable products that will bring in cash to the company next month.

To solve this, Generally Accepted Accounting Principles allow companies to chalk down the profit from products as they are finished and enter inventory. So far, everything is fine and dandy. The problem, of course, occurs when, say a team of top executives has a multi-million dollar bonus program that hinges on meeting certain profitability targets. If it seems that they are about to miss out on a big slice of cheese, all they have to do is ramp up production and let inventories swell. As profit is recognized from each unit leaving the conveyer belt, they don't have to worry about actually getting the stuff sold in order to cash in their fat bonus.

Unfortunately, these are artificial profits, as now you have a bloated inventory that costs money every day just by sitting there. Furthermore, you may have to sell it a discount just to get rid of the pile, thus cutting deep into the profits that were already recognized. It's like getting an advance, fritter away the money, and then discover that the actual sum you're about to receive is less than what you first thought. This is especially bad in tech-heavy industries, which are notorious for having short shelf lives. Would YOU pay full 1999 price for an old-fashioned computer?

This brings us back to the initial example of the one-person manufacturing shop. According to current accounting standards, you could make yourself a millionaire by never selling a single unit while stashing worthless products in a big circus tent in the back yard. This is of course absurd for an individual, but a big corporation can pull it off - in the short-term - thanks to its sheer size.

Next time you consider buying a stock, keep a close watch on inventories. Growing inventories is not necessarily a sign of foul play, but be wary of strange coincidences of generous bonus packages being paid out. And besides, foul play or not, growing inventories are rarely a good sign, as it means the company is producing more than the customers are willing to buy.

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