Inventory Is Especially Important to InvestorsWhen looking at a company's current assets, you need to pay special attention to inventory. Inventory consists of merchandise a business owns but has not sold. It is classified as a current assets because investors assume that inventory can be sold in the near future, turning it into cash.
To come up with a balance sheet amount, companies must estimate the value of their inventory. For instance, if Nintendo had 5,000 units of its new video game system, the Game Cube, sitting in a warehouse in Japan, and expected to sell them to retailers for $300 each, they would be able to put $1,500,000 on their balance sheet as the value of their current inventory (5,000 units x $300 each = $1.5 million).
The Risk of Too Much InventoryThis presents an interesting problem. When inventory piles up, it faces two major risks. The first is the risk of obsolesce. In another year, few stores will probably be willing to buy the Game Cube video game system for $300 simply because a newer, faster, and better system may have come along. Although the inventory is carried on the balance sheet at $1.5 million, it may actually lose value as time passes. When you hear that a company has taken an inventory write-off charge, it means that management essentially decided the products that were sitting in storage or on the store shelves weren't worth the values they were stated at on the balance sheet. To correct this, the company will reduce the carrying value of its inventory.
If a year passes and Nintendo still has 3,000 of the 5,000 units in storage, the executives may decide to lower their prices hoping to sell the remaining inventory. If they lower the Game Cube's price to $200 each, they would have 3,000 units at $200. Before, those 3000 units were stated at a value of $900,000 on the balance sheet. Now, because they are selling for less, the same units are only worth $600,000. The risk of obsolesce is especially present in technology companies or manufacturers of heavy machinery.
Inventory SpoilageAnother inventory risk is spoilage. Spoilage occurs when a product actually goes bad. This is a serious concern for companies that make or sell perishable goods. If a grocery store owner overstocks on ice cream, and two months later, half of the ice cream has gone bad because it has not been purchased, the grocer has no choice but to throw it out. The estimated value of the spoiled ice cream must be taken off the grocery store's balance sheet.
The moral of the story: the faster a company sells its inventory, the smaller the risk of value loss.
This page is part of Investing Lesson 3 - Understanding the Balance Sheet. To go back to the beginning, see the Table of Contents. If you have already read this lesson, you can skip directly to the Balance Sheet Quiz.