Educate Yourself - B&H 101 - "Turns" for the better

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"Turns" for the better
by Charles B. Carlson, CFA
Dow Theory Forecasts

I'm about to give you the single most powerful tool for evaluating a company, so read closely.

If you knew nothing about a company other than how quickly it moves inventory (especially relative to its competitors), you would probably be able to make a reasonably intelligent decision about that company's stock. Why? Simple.

Successful companies make stuff customers want now.

After all, the sole reason for a company's existence is to provide goods and services to the marketplace. If those goods and services see shrinking demand, declines in profit and revenue - and stock price - are often not far behind.

Fortunately, investors can analyze demand for a company's goods and services by examining the inventory turnover ratio.

The inventory turnover ratio is determined by dividing the company's cost of goods sold by average inventory. The numbers needed to compute the inventory turnover ratio are available from the company's quarterly and annual financial statements. These statements may be obtained from the company or online at the Securities and Exchange Commission's Web site -- www.sec.gov.

Another way to look at the inventory turnover ratio is to convert it to a "days to sell inventory" number. You derive this number by dividing 365 by the inventory turnover ratio. For example, if a company's turnover ratio is 3.65, it sells inventory every 100 days (365 days divided by 3.65).

A falling inventory turnover ratio (i.e. an increase in the "days to sell" number) means a company is taking longer to sell its inventory. A slowdown in inventory turnover could be a red flag for a variety of ills, including product obsolescence or pricing problems.

Inventory turnover, like most financial ratios, works best as a comparison tool within industries. When you look at inventory turns, also consider a company's gross profit margins (gross profit divided by revenue) and, to a lesser extent, its receivable turnover ratio (sales divided by accounts receivable). After all, a company can move inventory simply by cutting prices or granting overly generous credit arrangements. However, price cuts will show up in the company's gross profit margins, and Wall Street does not like to see declining gross profit margins. Wall Street also does not like to see lengthening collection periods.

The inventory turnover ratio also proves a useful tool when you go bargain hunting for beaten-down stocks. A big part of any company's rebound is a better bottom line. An improving inventory turnover ratio may be a confirming indicator that a company's products are seeing better demand.

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