Inventory, Determining Inventory

Inventory is a current asset account found on the balance sheet, consisting of all raw materials, work-in-progress, and finished goods that a company has accumulated. It is often deemed the most illiquid of all current assets and, thus, it is excluded from the numerator in the quick ratio calculation.

The ending balance of inventory for a period depends on the volume of sales a company makes in each period.

You can calculate this amount with the following information:

• Total valuation of beginning inventory. This information appears on the balance sheet of the immediately preceding accounting period.
• Cost of goods sold. This information appears on the income statement of the accounting period for which purchases are being measured.
• Total valuation of ending inventory. This information appears on the balance sheet of the accounting period for which purchases are being measured.

The formula for this is as follows:

Ending Inventory = Beginning Balance + Purchases – Cost of Goods Sold

Inventory and COGS

Ending inventory is also determined by the accounting method for Cost of Goods Sold. There are four main methods of inventory calculation: namely FIFO (“First in, First out”), LIFO (“Last in, First out”), Weighted-Average, and the Specific Identification method. These all have certain criteria to be applied and some methods may be prohibited in certain countries, under certain accounting standards.

In an inflationary period, LIFO will generate higher Cost of Goods Sold than the FIFO method. As such, using the LIFO method would generate a lower inventory balance than the FIFO method. This must be kept in mind when an analyst is analyzing the inventory account.

Turnover and Accounts Payable

The average inventory balance between two periods is needed to find the turnover ratio, as well as for determining the average number of days required for inventory turnover. In these calculations, either net sales or cost of goods sold can be used as the numerator, although the latter is generally preferred, as it is a more direct representation of the value of the raw materials, work-in-progress, and goods ready for sale.

Accounts payable turnover requires the value for purchases as the numerator. This is indirectly linked to the inventory account, as purchases of raw materials and work-in-progress may be made on credit thus, the accounts payable account is impacted.

Inventory Best Practices

Inventory best practices include careful inventory management. The business saying “If you can’t measure it, you can’t manage it” applies here. The first best practice is to track inventory. Others include:

Invest in a Cloud-based Inventory Management Program:

Cloud-based inventory management systems let companies know in real time where every product and SKU are globally. This data helps an organization be more responsive, up-to-date, and flexible.

Carry Safety Stock:

Also known as buffer stock, these products help keep companies from running out of materials or high-demand items. Once companies deplete their calculated supply, safety stock serves as a backup should the level of demand increase unexpectedly.

Use Batch/Lot Tracking:

Record information associated with each batch or lot of a product. Some businesses log precise details, such as expiration dates that provide information about their products’ sellable dates. Companies that do not have perishable goods use batch/lot tracking to understand their products’ landing costs or shelf lives.

Start a Cycle Count Program:

Save time, money and customers. Cycle counting benefits extend well past the warehouse by keeping stock reconciled and customers happy.

Inventory Turnover

Inventory turnover is the number of times a company sells or uses an item in a specific timeframe. The number can reveal whether a company has too much inventory on-hand. To determine inventory turnover, use the following equations:

Average inventory = (Beginning Inventory + Ending Inventory) / 2

Inventory turnover = Sales + Average Inventory