Which Points Could Be The Sign Of Overvalued Inventory?
Below is a question I answered on Quora yesterday that I thought would be valuable to share here. The below answer is unedited except I added some links and pictures for further clarification.
At first glance this seems like it would be something hard to figure out. But it’s not once you know how interpret three ratios and numbers from the companies financials.
First, go to a site like Morningstar – Independent Investment Research and pull up the balance sheet and key ratios tabs in separate pages.
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Go to the key ratios tab. From here scroll down until you see key ratios and click on the efficiency ratios tab. Look at the cash conversion cycle over a several years.
If the CCC it rising over the years this could mean the company is having issues selling inventory. And if they’re having trouble selling inventory it could mean the inventory will need to be written down at some point. And is overvalued.
To continue your search for overvalued inventory now go to the balance sheet tab you have open. Look at two things here: Inventory and accounts receivable and the relation in these numbers over time.
As an example, if accounts receivable rises 5% year over year but inventory rises at 15+% year over year this could mean the company is having issues selling inventory i that time.
This scenario is almost always bad news for the company and shareholders unless the company can correct the issues going forward.
Why? Because this may mean it will have to write some of the inventory down (or off altogether) at some point. Again, meaning the inventory is overvalued on the balance sheet.
Watching the three above things won’t catch everything. But its a good start in figuring out if inventory may be overvalued. And have to be written down or off the balance sheet at some point.
Remembering this one simple rule will help a lot when evaluating companies as well… Accounts receivable and inventory should rise or fall at about the same amount over time. If they don’t you need to find out why because there could be some serious issues.
What are your thoughts on overvalued inventory and using the cash conversion cycle? And did I miss anything? Please let me know in the comments below.
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