IF YOU ASKED the average company president what he (hey, don't blame us for the averages) thinks of inventory, he'd likely sigh and tell you it's a necessary evil. Manufacturers have warehouses filled with raw materials, component parts and finished goods to help fill orders. Retailers have stock waiting to be sold. For every moment any of it sits idle on the shelves, it costs the company money to store and finance. That's why managers strive with all they've got to have as little inventory on hand as possible.
Certain types of companies (manufacturers, retailers) by nature must carry more inventory than others (software makers, advertising companies). So as an investor you want to look for two things here: First, does one company in a given industry carry more inventory as a percentage of sales than its rivals? Second, are its inventory levels rising dramatically for some unexplained reason?
You can't look at inventory in isolation. After all, if a company's inventory level increased 20% but sales grew at a rate of 30%, then the increase in inventory should be expected. The warning sign is if inventory spikes despite normal growth in sales. In 1997, for instance, the stock of high-flying apparel maker Tommy Hilfiger got nailed when its inventories suddenly rose 50% spooking Wall Street analysts, who figured the popular men's wear maker had lost its edge among teenage boys. Tommy eventually righted the situation (it had more to do with inventory management than fashion sense) and the stock recovered. But a lot of investors lost money along the way.
A helpful number to look at is the inventory-turnover ratio. It's annual sales divided by inventory and it reflects the number of times inventory is used and replaced throughout a year. Low inventory turnover is a sign of inefficient inventory management. For example, if a company had $20 million in sales last year but $60 million in inventory, then inventory turnover would be 0.3, an unusually low number. That means it would take three years to sell all the inventory. That's obviously not good.
There's no rule of thumb when it comes to turnover. It's best to make comparisons. If a retailer had a turnover of 4, for example, and its closest competitor had turnover of 6, it would indicate that the company with higher turnover is more efficient and less likely to get caught with a lot of unsold goods.