A widely used method is the average ratio of inventory to sales over a
recent or representative multiyear period applied to the sales
forecast. This works well in the absence of unusual amounts of
volatility in a company's performance.
To see how stable the multiyear average ratio of inventory to sales is
or if it is concealing a trend, calculate the inventory turnover for
each year by dividing the cost of goods sold by the average inventory.
Significant changes in the inventory turnover that are sustained over
multiple years may indicate that the ratio of inventory to sales
should be adjusted to account for a trend.
In general, greater emphasis on inventory turnover and efficiency has
resulted in a gradual decline in the ratio of inventory to sales.
This has been particularly pronounced during the recent economic
slowdown in the United States. In fact, some experts believe that the
present inventory levels are unsustainable low.
Where this rule of thumb becomes inaccurate is when a firm's
circumstances change abruptly. If sales are forecast to rapidly
decline, it is unlikely that inventories can be reduced as rapidly to
match their historical ratio. In contrast, if sales are forecast to
rapidly increase, inventories are likely to be drawn down, at least in
the short term. This can have a dramatic effect on a firm's financial
statements if it is using last-in, first-out (LIFO) accounting for
inventory valuation.
When demand increases rapidly and inventories are reduced
considerably, a firm may dip into one or more LIFO layers. In this
case, income is increased because older, typically less valuable
inventory is used to calculate the cost of goods sold. As a result,
the inventory value decreases less than one would ordinarily expect
based on current acquisition costs. Firms typically provide a
footnote in their financial statements regarding the impact of dipping
into LIFO layers when it occurs.
Other factors to consider when making an inventory forecast are
unusual opportunities to purchase inventories at good prices, new
production facilities opening, closure of production facilities,
acquisitions, and divestitures. In the absence of considerable
changes to a company's structure and operating environment, though,
applying the ratio of inventory to sales to the sales forecast is a
reasonable forecasting method.
Sincerely,
Wonko
Sources:
Principles of Corporate Finance, Fourth Edition, Brealey & Myers,
McGraw-Hill Inc. (1991), pages 681, 724, and 725.
Financial Accounting, Stickney, Weil & Davidson, Harcourt Brace
Jovanovich, Inc. (1991) pages 284-287.
"Don't Fret Yet About Rising Inventories" by Amey Stone, BusinessWeek,
(August 12, 2004) http://www.businessweek.com/bwdaily/dnflash/aug2004/nf20040812_0417_db042.htm. |
