It's not just what a retailer sells but how the company manages its inventory.

Fail to keep enough stock on hand, and you miss out on sales as customers leave for competitors with stocked shelves. Have too much inventory, however, and you tie up cash while exposing yourself to increased risk from obsolescence or changing market conditions. How well a company walks that tightrope can mean the difference between long-term success and failure in the retail space.

In this clip from the Industry Focus: Consumer Goods podcast, Sean O'Reilly and Vincent Shen explain why inventory management is something that every investor should understand if looking at retail, as well as some key metrics they can use to gauge a company's operations.

A full transcript follows the video.

This podcast was recorded on May 17, 2016. 

Sean O'Reilly: For listeners who are rolling their eyes right now, not only because of our bad jokes, but also because of the fact that we're about to talk about inventory management of retailers, can you draw them in a little bit, explain what it is, maybe jazz it up a little?

Vincent Shen: Sure. Broad context, this is the idea that there's a lot involved in when you walk down the aisle at a grocery store, a clothing store, or even a big box store like a Target or a Wal-Mart. There's a lot involved with keeping the shelves stocked with the products you want. There's SKUs, which are essentially the numbers they assign to identify these products. When you have, let's say, a thousand store locations, and each of the store locations, at a big box store, for example, has potentially tens of thousands of SKUs. This becomes a huge, huge operational challenge.

When you're looking at a company and trying to generally identify how well it's managing its inventory, on the investing side, we generally like to use two metrics. The first one of those is inventory turnover. That basically tells us how many times a company will sell through the inventory it has in a given period.

This number is calculated by cost of goods sold over whatever time period you want to use. Traditionally it's on a trailing 12-month basis. You divide that by its average inventory balance during the period. So you could take Q4 inventory for 2014, and then the ending balance in 2015, average those two numbers, and you'll get essentially 5 or 10 or 15 times, basically how many times they turned through their inventory in that year period, if you're going by trailing 12 months.

Related to this number, you can also calculate their days of inventory outstanding. This number basically tells you how much inventory they have on hand, measured by how many days it would take them to sell through the balance they currently hold. I really like this number because it puts it into perspective how quickly a company can sell through its inventory and how much they have. It's all within the metric, days or weeks.

O'Reilly: That's kind of the name of the game in retail. Assuming that items are being sold for a profit, the more quickly you can sell things, the more you can use that money to buy more inventory, and it keeps on spinning.

Shen: I'm really glad you touched on that, because the ultimate idea is that these companies are pouring resources and money into whatever goods they're producing or selling or acquiring from suppliers. The faster they can convert that inventory into revenue and cash, it's very beneficial to them. Being able to optimize, and make its management of inventory as efficient as possible, is really important to the margins and profitability of any company.

For that days of inventory outstanding number, a lower number is generally preferred. The idea is, you can sell through it very quickly. At the same time, if it's too low, you run into the issue of potentially leaving money on the table if, for example, you don't forecast demand well ...

O'Reilly: You're pricing to sell, yeah.

Shen: And, at the same time, you don't foresee outsized demand, you can't meet that, and you leave money on the table. Another thing to keep in mind with these two metrics is, on their own, they don't tell you quite as much as when you compare them to their peers or their overall industry or sector. That's where you really see, through that comparison, how well they're doing.

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