Three Things to Check When a Company's Inventory Rises
Break down inventory growth by quantity, cost, and production stage to distinguish sales preparation from weak demand. Learn why write-downs and lower inventory do not guarantee cash recovery.
Rising inventory alone does not establish either deteriorating performance or a business boom. Check what is accumulating and how much, whether inventory is growing faster than cost of sales, and whether achievable selling prices are holding up. Stockpiling raw materials and accumulating unsold finished goods have different implications, even though both are inventory.
Break inventory into raw materials, work in progress, and finished goods
More raw materials may reflect advance procurement for expanded production, while more work in progress may reflect long manufacturing cycles or process delays. More finished goods may result from preparation for shipment or delayed sales. Rather than comparing totals alone, relate the inventory breakdown in the notes to explanations of production and shipments. Also distinguish higher carrying amounts caused by rising raw material unit costs from accumulated quantities. If quantities are not disclosed, do not equate growth in value with growth in volume; record that the information needed to assess the price effect is insufficient.
Use cost of sales as the denominator for inventory days
Because inventory is recorded primarily at cost rather than selling price, turnover analysis generally matches it with cost of sales. Divide average inventory by cost of sales for the period, multiply by the number of days in that period, and compare with the same period a year earlier. Seasonal goods may normally build up just before peak demand. Also examine whether higher production has left fixed manufacturing costs in inventory and how much will be expensed when the goods are sold. Reviewing gross margin alongside inventory days helps distinguish production efficiency from discount selling as the cause of a decline in days.
A write-down is not cash collected from a sale
IAS 2 describes the principle of measuring inventories at the lower of cost and net realizable value. An inventory write-down reduces both inventory carrying value and earnings, but the adjustment itself does not mean cash has been collected. Balances may also normalize after old inventory is scrapped or sold at reduced prices. Do not assume that a decline in inventory generates an equal amount of cash. In industries with falling prices, track valuation allowances, actual disposal losses, and subsequent sales margins together to capture the cost of clearing inventory. If gross margin plunges while inventory is being reduced, ask how much was sold at normal prices and how much was cleared at a discount. If sales volumes are disclosed, check whether quantities increased without a recovery in sales value.
Worked example
Hypothetical example: Annual cost of sales of KRW 36.5 billion and average inventory of KRW 6 billion give inventory days of 60 days. If cost of sales rises to KRW 43.8 billion and average inventory to KRW 9.6 billion the next year, inventory days increase to 80 days. If a KRW 1.5 billion write-down reduces closing inventory that year from KRW 11 billion to KRW 9.5 billion, do not treat that KRW 1.5 billion as a cash improvement from collecting sales proceeds.
What to check
- At which production stage is inventory growth concentrated?
- Are data available to separate price increases from quantity growth?
- Do average inventory and cost of sales cover matching periods?
- Have you distinguished write-downs, scrapping, and discount sales?
Sources and primary materials
This is educational material about research methods. For an actual company decision, verify the filings and primary sources for the relevant period.