The 7 critical items to read first in an annual report in 20 minutes (Part 4 of 9)

This is a series of articles describing how to quickly understand the key aspects of the annual report from a company that you have invested in with your hard earned money. This series started with an overview post on November 30, 2010.

3. Inventories

Many companies have varying levels of inventory over the course of the year. Since the Annual Report is always at the same time, it is worthwhile to see how this metric changes from year to year.

Once again, we are not overly concerned with the growth or reduction of inventory. We are more concerned with why it changed or didn’t change. In general, the company needs inventory to level out pricing and supply chain issues but inventory tends to tie up cash. Also, in some industries the inventory may have less value over time if it is not turned adequately.

The easiest way to find information about inventory in the Annual Report is to do a search on the term “inventories” using your search capability in your reader or browser. Once you find the table that shows the increase or decrease, there will be a few paragraphs discussing the metrics. Does it make sense to you? Does it cause you any concerns?

As a very general rule of thumb, the inventory level shouldn’t change much from previous years. If it does change, in general it should be going down. If the inventory is going up relative to the growth of the company’s sales, you should make sure that the management team has an excellent reason for this increase. If the inventory decreases more than 5-10% from its historical values, you should make sure the management has a reason for that change as well.

If you don’t like the reason for the change (or lack of change) in the discussion, this may be a signal to you to get this company out of your portfolio. Inventory levels are often a ‘mine canary’ for problems in the operations of the company. You aren’t a large enough stockholder to call the Chairman and have the problem fixed, so your choice is to continue as a stockholder or sell your holdings. Don’t think about it any more than that simple test.

Here are the links to all 9 posts of the series:

1. The 7 critical items to read first in an annual report in 20 minutes (Part 1 of 9)
2. The 7 critical items to read first in an annual report in 20 minutes (Part 2 of 9)
3. The 7 critical items to read first in an annual report in 20 minutes (Part 3 of 9)
4. The 7 critical items to read first in an annual report in 20 minutes (Part 4 of 9)
5. The 7 critical items to read first in an annual report in 20 minutes (Part 5 of 9)
6. The 7 critical items to read first in an annual report in 20 minutes (Part 6 of 9)
7. The 7 critical items to read first in an annual report in 20 minutes (Part 7 of 9)
8. The 7 critical items to read first in an annual report in 20 minutes (Part 8 of 9)
9. The 7 critical items to read first in an annual report in 20 minutes (Part 9 of 9)