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.
Related or Semi-related Video
Finance: What is Work In Process Invento...2 Views
finance a la shmoop what is work-in-process inventory well you're a
car assembly company named Shmord for any given car you have to buy a ton or [Lots of cars in a parking lot]
two of steel and four tires couple of windshield wipers a bunch of [Wipers on in the rain]
hoses wires vats a glass carpet and yards of rich Corinthian leather [Pictures of the materials]
with none of this stuff yet assembled into the car you're gonna sell it to a
dealership for twenty eight thousand eight hundred twenty three dollars it's [All the materials in a list]
just the inventory that is work in the process of being built why is it
important well for a lot of companies their inventory is highly valuable and
it comprises a lot of the actual asset value of the company it's also something
that clever accounting can jerk around to make the books look better or worse [Guy reading an accounting book]
than they actually are like there's a mountain of tires sitting in a portable [Tires piling up]
warehouse 12 feet off of the perimeter the border of the factory just sitting [A warehouse covers the tires]
there has Shmord paid for them well they're kind of sort of delivered but
not really so do those tires get counted as inventory what if you dragged the
porter shed twelve to fourteen feet closer to the factory then are they [The warehouse comes up to the factory perimeter]
counted as delivered and then you have to pay for them so then maybe you do so
and you recognize them as an asset maybe okay you get it
lots of accounting tricks that can be played in the short run in this category [Guy juggling balls with dollar signs on]
eventually however work-in-process inventory is work in the process of
being built into a finished product but that's still sitting there in inventory [Someone welding a car]
not yet sellable to people and the big accounting trick of moving the P beneath [A pea is hidden under one of three walnut shells]
the walnut shells only fools investors for so long eventually they're gonna
focus on revenues and free cash flow profits to be sure if you're not [Someone swipes away the walnut shells to reveal the pea]
tricking them well the big idea in this term set is that inventory takes a few
different forms it can be raw like just plain old tires or even the rubber to [Picture of tires]
then go be made into tires like sitting in a shed somewhere inventory can be [Bricks of rubber are thrown into a shed]
half-baked like a semi assembled chassis or like a thousand of them just sitting
around waiting to be uploaded with an engine and body and hydraulics and a [Computer screen showing a progress bar with each component of the car appearing]
steering wheel and it goes along you know the assembly process until finally
at the end of all of that work in process inventory stuff is in fact [Guy talking in front of the Shmord factory]
magically then turned into actual inventory that is sellable to a client [New cars in storage]
got it or a buyer whatever you want to call them okay
we didn't say it had to be pretty inventory just inventory [Guy smiling walking up to a Shmord dealership and a tiny car appears]
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