Inventory management
Days Sales in Inventory (Annual)
= 365 x (Inventory ÷ COGS)
Days Sales in Inventory (Quarterly)
= 91.25 x (Inventory ÷ Quarterly COGS)
 Analyze y-o-y and sequentially
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Applied to components:
Days Sales in Raw Materials(Annual)
= 365 x (Raw Materials ÷ COGS)
Days Sales in Work in Process(Annual)
= 365 x (Work in Process ÷ COGS)
Days Sales in Finished Goods(Annual)
= 365 x (Finished Goods ÷ COGS)
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Positive divergence
– When raw materials and work in process pile up
compared to finished goods
Negative divergence
– When finished goods pile up relative to raw
materials and work in process
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Sale of Written-Off Inventory
 Margins are artificially inflated when companies write-off
inventory and then sell them later
 Example: Cisco
“As a result of the restructuring program and decline in forecasted revenue,
we recorded restructuring costs and other special charges of $1.17 billion
classified as operating expenses and an additional excess inventory charge
classified as cost of sales. The excess inventory charge recorded in the third
quarter of fiscal 2001 was $2.25 billion. This excess inventory charge was
subsequently reduced in the fourth quarter of fiscal 2001 by a $187
million…”
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Other items to watch out for – Assets side
 Allowance for doubtful accounts (ADA)

Compare the ADA as a % of gross accounts receivable:
ADA ÷ (ADA + net accounts receivable)

ADA should track gross receivables
 Goodwill and intangibles


Large goodwill and intangibles could mean assets are
overvalued due to acquisitions
If goodwill changes without an acquisition, it could mean
management adjusted a purchase price for an acquisition
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 Other current assets


Companies can treat expenses as if they were assets (this
is known as capitalizing an expense). This means
expenses don’t show up in the income statement (so
earnings are higher), but show up in the balance sheet
instead. Capitalized earnings may be called “other
current assets”.
When (Other Current Assets ÷ Revenues) increases, it
could mean companies are capitalizing expenses.
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Other items to watch out for – Liabilities side
 Deferred revenue



Revenue a company receives before it delivers the
product or service.
Days in deferred revenue (DDR)
= (91.25 x deferred revenue) ÷ quarterly revenue
If DSO – DDR is declining, the company is generating less
deferred revenue relative to the terms it is offering
customers.
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 Accrued liabilities

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


Or, “other current liabilities”, or “other liabilities”
Reserves are often lumped into these categories.
A company taking serial charges could be building up
reserves. Reserves are usually set up to cover contingent
liabilities.
But companies can also be building reserves to smooth
income --- i.e., dipping into the “cookie jar”.
Check accrued liabilities relative to revenue. If it falls, it
could be an indication that the company reversed a
reserve giving an artificial boost to earnings.
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• Sources:
– Del Vecchio and Jacobs, What’s Behind the
Numbers?
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