On the heels of yesterday’s article, I received an e-mail from a friend this afternoon asking me about my thoughts on inventory turns and profit margins. To paraphrase: The math doesn’t work right, as the inventory turns don’t affect the profit margins each year.
I didn’t do a good job of explaining it properly; so, let’s look at the “true” profit margin of a company.
The Low Cost Business
We all know that it’s better to have a low-cost business than a high-cost business. Companies with relatively small capital expenditures and fat profit margins should be chosen over those with high capital expenditures and thin margins, assuming all other things are equal.
If you can find good companies that generate tons of cash on a relatively small amount of invested capital, and you can buy those companies at a discount to their intrinsic value, you’ll probably find that your long-term investment results are quite satisfactory.
Profit Margin on One Inventory Turn
So…we turn to two businesses, each of which has a thin profit margin, to see how inventory turns can give us some insight into the economics of the company. Let’s first look at the economics of the business from a single sale perspective to show that they’re the same:
(Note: The number of “inventory turns” refers to the number of times a company must replenish its inventory throughout the year. If Walgreens orders one case of Coca-Cola each month, and sells one case each month, it will have “turned” its Coca-Cola inventory twelve times that year.)
| Company A | Company B | |
| Revenue | $ 100 | $ 100 |
| Cost of goods sold | 98 | 98 |
| Other expenses and taxes | - | - |
| Net income / Cash flow | $ 2 | $ 2 |
| Profit margin | 2% | 2% |
In this case, both businesses earned $2 on $100 of revenue. Their profit margins were 2% ($2 divided by $100). Fortunately, they lived in the land of Tina’s Family Therapy; so, no taxes or any other costs.
Both companies invested $98 in inventory (cost of goods sold), sold it for $100, and made a $2 profit. Simple enough.
Conventional wisdom would say that both businesses should be avoided. We’re supposed to look for businesses with wonderful economics, and a 2% profit margin is anything but “wonderful.” Then again, we’re all about being non-conventional around here.
Profit Margin on Multiple Inventory Turns
Same companies, but factoring one year of inventory turns into the mix:
| Company A | Company B | |
| Inventory turns | 12 | 2 |
| Revenue | $ 1,200 | $ 200 |
| Cost of goods sold | 1,176 | 196 |
| Other expenses and taxes | - | - |
| Net income / Cash flow | $ 24 | $ 4 |
| Profit margin | 2% | 2% |
Right off the bat, these companies may still look similar. Though Company A has greater sales and revenues than Company B, they both boast 2% profit margins and seemingly terrible economics.
Then again, these are businesses, not just numbers on a piece of paper. And the business of Company A is far superior to that of Company B from an owner’s perspective.
What Each Business Invested to Earn Their Income
Let’s first look at Company B. To generate $4 in income, it invested $196 in inventory (cost of goods sold), right? Wrong. Because it had two inventory turns, it invested $98 in inventory to generate $100 in sales, took the profit from that, reinvested the $98 in more inventory, and then turned another sale.
Essentially, Company B invested the same $98 twice to earn $4. Already see where this is going?
Company A invested $98 in inventory to earn $2, but was able to reinvest that $98 eleven more times to generate a total of $24.
Both companies invested $98 to earn $2, but Company A was able to reinvest it faster, thus generating six times more than Company B.
The “true” profit margin of Company A was not 2%, but 24%. The “true” profit margin of Company B was not 2%, but 4%. Here’s how it works:
True Profit Margins…as Bonds
Think of the true profit margin as a bond with a fixed interest rate. Would you rather have a bond paying 24% or a bond paying 4%? The answer is clear.
Company A and Company B both invested $98 into their business through the purchase of inventory. In essence, each purchased a $98 bond (the inventory), and that bond generates a certain amount of profit ($2). Except that Company A’s “bond” pays that $2 monthly while Company B’s “bond” pays $2 every six months.
Which company has better economics? They both have terrible profit margins from an accounting standpoint, but then again – accounting numbers are for the IRS. Business owners and investors follow the cash.
Which Company Will Grow Faster?
It’s pretty clear in the above example that Company A will have a better chance to grow faster than Company B. It generates more in sales, and it generates more cash. Let’s level the playing field. Instead of selling products for $100, Company B is selling higher priced goods. It buys products for $588 and sells them for $600. Both companies have the same revenues, cost of goods, net income, and profit margins:
| Company A | Company B | |
| Inventory turns | 12 | 2 |
| Revenue | $ 1,200 | $ 1,200 |
| Cost of goods sold | 1,176 | 1,176 |
| Other expenses and taxes | - | - |
| Net income / Cash flow | $ 24 | $ 24 |
| Profit margin | 2% | 2% |
So…which is the better investment?
Though it looks like we’ve leveled the playing field, we really haven’t. These are two very different businesses. To understand this, we have to work backwards.
How will Company A and Company B generate additional cash? With no other expenses, they each have three choices:
- raise the price of their products (e.g., from $100 to $105, from $600 to $630),
- lower their cost of inventory (e.g., find cheaper inventory at, say, $90 and $500), or
- sell more of their products.
If they can’t raise prices and they can’t find any cheaper suppliers, their only option is to sell more of their product. While that is great in theory, it ain’t so simple in the real world. Unless they have some magic formula for making cash appear out of thin air, how will they purchase additional inventory so that they can sell more of their finished product?
Assuming neither has cash in the bank or access to outside financing, they have one of two choices:
- require payment upfront, and then use the customer’s money to purchase inventory, or
- save up enough cash to purchase more inventory, using the funds of the business.
Some businesses can do the former; but, let’s assume that these two companies are retailers, and that their customers aren’t paying for clothes today, but willing to take delivery in sixty days. To get more inventory which will lead to more sales, the company’s must use the funds of the business.
But wait – neither company has cash in the bank! Okay – how long will it take before the companies can expand? That is…which company will grow faster?
| Company A | Company B | |
| Profits | $ 24 | $ 24 |
| Cost to purchase more inventory | $ 98 | $588 |
| Years until company can handle double sales volume |
4.1 | 24.5 |
In 4.1 years, Company A will have saved $98 from its $24 of profits – enough to purchase another unit of inventory. With two units of inventory both being sold concurrently, the company is generating twice as much cash.
It will take Company B 24.5 years to save up $588, if saving just $24 per year. As such, Company B will have to wait 24.5 years before it can double its cash flow.
Again – which company has the better economics: the one that can double every four years or the one that doubles every 25?
The Race is Over Before it Begins
If we fast forward and look at these two companies in 25 years, assuming that each tried to beef up their inventory at the end of the year (not 0.1 years into year 4), Company B has finally purchased another unit of inventory and will begin generating $48 a year in excess cash. Company A, on the other hand, has 465 units of inventory and is generating $11,160 in excess cash.
And while Company B has finally beefed up sales to $2,400 ($600 times 2 inventory turns times 2 units of inventory), Company A is generating $558,000 in sales – 233 times the amount of sales!
High Profit Margin/Low Turnover
Finally, consider this: A high profit margin business may have a very low “true” profit margin, and may be a candidate to avoid. When comparing a 2% profit margin business to a 10% profit margin business, many investors automatically assume that the 10% business is better.
That’s not necessarily true.
Everything else being equal, the 10% margin business with one inventory turn is no better or worse than the 2% margin business with five turns a year.
I apologize for any confusion I caused in this post.
Filed under: How to Value a Business
Very nice post Joe.
I have a little question for you. This approach is applicable to services companies, which have little or no inventory and the lilltle they have are a minor component of the value they deliver to the customer?
thanks form argentina, and sorry the bad english.
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Good illustrations of an important point.
Mauboussin and Kawaja discuss this concept in relation to online retailing. Their study is from 1999, but I don’t think it’s dated. If anything, their analysis is increasingly confirmed.
Here it is: http://capatcolumbia.com/...
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The number of inventory turns isn’t too hard to figure out if the financials don’t explicitly give them to you. What you do is this:
Take beginning inventory (i.e. inventory at 12/31/07), add ending inventory (i.e. inventory at 12/31/08) and divide by 2 (because you’ve got two data points). (You grab this information from the balance sheet; most financials will give you a year over year comparison, so the two numbers should be literally next to each other.) This will give you the approximate average of inventory during the year.
Then, look at cost of goods sold and divide that number by the average gotten above. And *boom* you have the approximate average inventory turnover. It’s not precise, of course, but it works well enough to get a rough idea.
Hope that helps, and that I didn’t make a stupid mistake someplace.
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I have a similar question to Emiliano. How could this idea translate into a services company that doesn’t sell inventory? Is there some way perhaps to use volume such as # of projects completed? Not sure how you’d find this information though unless it was discussed in MD&A.
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Emiliano: That’s exactly why service companies can be so lucrative – little to no inventory. Much of the revenue can go directly to salaries and expenses, leaving a lot left over for owners on an ongoing basis, but very little in a break-up.
Napoleon: Thanks for answering that! Quick and dirty, but it works.
BPal: For services companies, I would look more to revenue per employee because the employees are the inventory, so to speak.
Ankit Shah: As profits grew, more and more inventory was added and sold in an exponential way. After the first four years, the company could add one unit of inventory. But in year 24, it added some 100 units or thereabout – the power of compounding all those profits.
Mark: I haven’t looked at it in quite a while, but only because it hasn’t come across my radar again.
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Ankit: I actually get 458 units doing a year by year analysis. Maybe he has a different method or a nice formula (care to share, Joe?).
Joe: This is a great post, although I’d recommend changing “That is…which company will grow faster?” to “That is…which company can grow faster?”. It seems (in contradiction to the previous sentence) that you’re implying rising inventory = higher sales.
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I do not know if I understand correctly. I will give an example: xxx Inc has a profit margin of 20%, and an Inventory Turnover 2. Then the profit margin business is 40%. And zzz Inc has a profit margin of 3%, and an Inventory Turnover of 8. Then the profit margin business is 24%. This is correct?
Thanks to your blog, I am learning incredible things
PS: I am using the google tranductor.
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Thanks Joe … great lesson!
Thanks Nappy 14 … great clue! …but can’t persuade myself of the need of the average .. what for? and in that need shouldn’t we consider the price inflation … I try to calculate the last 5 yy!
my doubt is about maths as Ankit’s … he writes <in year 24, it added some 100 units or thereabout – the power of compounding all those profits> … the same to me… can’t figure out < 465 units of inventory> as Joe does
fabio from italy
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Chris B: You may be right. I don’t have the spreadsheet any more and I whipped it together quickly. The point is – it has significantly more!
Allen: Glad you enjoyed it. Thanks!
Alberto: The “profit margin” as reported for those two businesses would be 20% and 3%, and that’s the point of this article. The “true” profit margin gives us a better look inside the business and may show us which one has the better economics. Make sense?
Inventory turns and turnover are the same. If you divide the cost of goods sold in a year by the average level of inventory, you’ll figure out the inventory turns/turnover.
fabio64: See my comment to Chris and please excuse me if I didn’t provide precision math. I did it quickly to prove a point.
Jeremy Horn: That’s right. Think of it like this => How much money must be invested in the business (in this case, inventory) to generate profits, and can those profits be reinvested quickly and efficiently?
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Hey Joe,
I’m trying to understand the nuts and bolts of how a balance sheet
works.
So, assets = liabilities equity.
When a company spends cash on something other than an asset, such
as operating costs. This depletes cash (assets). I figured this is balanced
on the other side of the equation, by depleting owners equity?
If so, is this shown on any line in owners equity?
Now, what if a company spends cash on buying another asset. Then I
figured cash would just be transferred into another asset and so there
would be no need to balance the other side of the equation? is this
correct?
Thanks
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Ari -
Cash spent on operating costs would flow through the income statement. You would not have line of sight to it on the balance sheet. The net income of the company (or net loss) = all incomes less all expenses. The net income or net loss would then adjust retained earnings, which is a subset of owners equity.
Example:
$100 Revenue
($80) Expenses =
$20 Net Income
If beginning retained earnings was $100, then ending retained earnings would be $120.
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Joe,
You’re essentially talking about the investment return ratios: ROA, ROE and ROIC to determine the quality of a business. Company A in your example is more asset-light than B, basically because at any given time it needs to hold less inventory which is part of it’s assets. So it would boast a higher ROA, and ROIC for example. Whereas B is more capital intensive.
So, why would you need to look at inventory turns additionally?
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simon,
I think Joe was just breaking down those ROI formulas into their components to get closer to the answer to the question “Why?” As in, “why is Company A better than Company B?” You could just say “it has a higher ROC,” or you can break down the ROC into its component parts (inventory turns, profit margin, leverage) and find out why that is so. Joe did that in a more elegant and thoughtful way.
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david: Hopefully getting off track helped provide a touch of sanity and clarity in an insane time!
simon: It wouldn’t automatically boast a higher ROA because the company might hold other assets weighing on that number. Inventory turns helps you see how effective the company is at turning dollars invested in inventory into extra profits, regardless of the rest of the business and its assets. In essence, inventory turns is another piece of the puzzle. In and of themselves, none of these numbers mean anything. Taken together, you can begin to find additional strengths and weaknesses in a business.
Jeff: I don’t hear that often: That guy screaming ‘F Wall Street’ – he’s elegant! Thanks!
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Return on equity is much better than a straight comparison between the profits of two companies. A company that can generate high returns on equity is going to have a better chance of growing or providing better returns to shareholders than a company that has a hard time generating profits on its immense asset base.
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Very well explained joe. i believe one must also take into account the nature of the product being manufactured while determining profitability. For a manufacturer of disposable needles and syringes its not difficult to maintain high inventory turnover and sales growth whereas for pc manufacturers or other capital intensive products like tractors, houses and cars it might be difficult to maintain high inventory turnover and also to grow their sales becoz their existing sales compete with their potential sales.
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Instead of inventory turnover, I use the cash conversion cycle, or CCC.
It is more accurate for companies that manufacture and distribute goods. It also includes accounts recievable. Companies can have high inventory turnover, but if it takes them a long time to manufacture the goods (if they both manufacture and distribute) and collect recievables, then the inventory turnover may not paint an accurate picture. CCC basically measures the amount of time it takes for one dollar thats invested into the business to go through all the steps to become one dollar (and some cents) profit.
The cash conversion cycle is hard to find. You can calculate it yourself (investopedia has a few good articles on to do calculate it). I can only find it on one website that has it for you.
http://ih.advfn.com/p.php...;cb=1267981127&symbol=ARDNA
Go to the very bottom under “efficiency ratios”
For this company, the CCC is 29, so about once a month a dollar invested becomes profit.
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I can honestly say that I have never heard of or considered true profit margins. Thanks Joe! This is a game changer for me. Time to update my stock screener!
Thank you for sharing all this knowledge with us. The book was awesome too.
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