Taking Inventory of Inventory

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Ever wonder how to make sense of "inventory" line item that you'll often find on a company's balance sheet?

Inventory refers to all items in a company's production pipeline. There are three main categories of inventory: raw materials, work in progress, and finished goods. Imagine PlastiCrania Inc. (ticker: NOGGN), which makes Mr. Burrito Head toys. Making the toys involves ordering, receiving, storing, and using raw materials, such as chemicals, cardboard, and paint. These are assembled into finished products. At any time, PlastiCrania's inventory is likely to include vats of plastic, half-assembled burrito molds, finished boxes waiting to be shipped to distributors, and returned products from retailers.

If a company carries too little inventory, any shortages that occur will hold up production. Too much inventory will generate high storage costs and tie up capital that could be used elsewhere. Finished goods sitting on shelves a long time also pose a risk of not being sold due to obsolescence. In recent years, many American companies adopted "just-in-time" inventory systems pioneered by the Japanese. These systems have firms holding precisely the minimum necessary inventory, replenishing supplies continually as needed.

When you see a firm's inventory levels recorded on its balance sheet, compare them with those from the year before, and with revenue growth. If inventory is rising faster than revenues, it could signal a sales slowdown. If inventory growth lags sales, either the company is not meeting demand or it's successfully tightening controls on production processes and distribution.

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