Inventory

Inventory sits at the junction of the balance sheet and the income statement. Every rupee of cost is either on the shelf as an asset or in cost of goods sold as an expense, and deciding which is a judgement that moves profit one-for-one.

The basic identity

$\text{Opening} + \text{Purchases} - \text{Closing} = \text{Cost of goods sold}$

Rearranged, the consequence is stark:

A higher closing inventory produces a lower cost of goods sold and therefore a higher profit. Not indirectly — pound for pound. That is why inventory is the account most often used to flatter a result, and why chapter 14 of the Company analysis subject treats it as an earnings-quality signal.

What goes into cost

Inventory is carried at cost, which includes purchase price, conversion costs, and other costs incurred in bringing the item to its present location and condition.

What does not belong: selling costs, most storage costs, administrative overhead, and abnormal waste. Those are expensed as incurred.

The line matters because capitalising a cost into inventory defers it. A cost moved from the income statement onto the balance sheet raises this year's profit and lowers a later year's.

Cost formulas

Identical units bought at different prices need a convention for which cost leaves when a unit is sold.

FIFO — first in, first out. The oldest costs move to cost of goods sold; the newest remain on the balance sheet.

Weighted average — a blended cost per unit, recalculated as purchases arrive.

In a period of rising prices, FIFO charges older, cheaper costs to expense, so it reports higher profit and a higher inventory value than weighted average. Neither is wrong; they are different conventions, and two otherwise identical companies using different ones are not comparable without adjustment.

The convention must be applied consistently and is disclosed in the accounting policies, so this is checkable rather than hidden.

Net realisable value

Cost is a ceiling, not a value. Inventory is written down when it will not sell for what it cost — measured at the lower of cost and net realisable value, the estimated selling price less the costs to complete and sell it.

A write-down is an immediate expense. This is where the judgement is sharpest:

• Deciding stock is still worth cost keeps profit high this year and leaves the problem on the balance sheet.
• Writing it down takes the pain now.

A company that never writes anything down in a competitive, fast-moving category is making a claim worth checking, and the claim is in the notes rather than in the numbers.

Why rising inventory is a signal

Inventory growing faster than revenue means stock is accumulating relative to how fast it sells. Three readings:

Benign — building ahead of a launch, a seasonal peak, or securing supply at a good price. Usually explained in the management discussion.

Concerning — demand slowed and production did not. Inventory days rise, and cash is consumed.

Serious — the stock will not sell at cost and has not been written down. Profit is overstated by the write-down not taken.

The ratio to compute is inventory days:

$\frac{\text{Inventory}}{\text{Cost of goods sold}} \times 365$

The disclosure that separates the three is the note on inventory write-downs recognised in the period. A large inventory build with no write-downs in a category where prices fall is the combination worth questioning.

The consequence for cash

Inventory is one of the three working-capital accounts that consume cash as a business grows (chapter 5). Stock is cash converted into goods, and it stays converted until somebody buys them. A company reporting record profit while inventory balloons is reporting an accrual result that its bank balance does not share.

The point

Cost of goods sold is opening inventory plus purchases minus closing inventory, so a higher closing figure raises profit one-for-one — which is why the account attracts manipulation. FIFO and weighted average are conventions, not truths, and in rising prices FIFO reports more profit. Inventory is carried at the lower of cost and net realisable value, so refusing to write down is a decision that moves profit between years. Inventory growing much faster than revenue needs an explanation, and the write-down note is where it is found.