Help me get the intuition here. I know high inventory sales ratios are predictors of slowing ahead. Managers are having difficulty off loading product or sales have declined, which causes an increase in the ratio.
What trips me up is in thinking the reverse could be true, that managers expecting a stronger economy ahead would increase inventory levels before sales catch up.
I am having difficulty figuring out why one case would be true while the other wouldn’t.
If manager thinks economy will grow, he stocks up on inventory so he isn’t understocked when demand hits, thus higher inventory sales. If that demand never materializes and economy starts to slow down, that inventory just sits on the shelf and maybe sales decline, thus higher inventory sales.
So if inventory/sales ratios are high, why do we conclude that a slowdown is predicted when it could just as well indicate that managers are expecting an increase in business activity?
This is a good question. I think the curriculum says it both ways actually. In one section that increasing inv/sales means economic growth ahead and in another that low ratios are followed by good stock returns…
I love this question solely because it pertains to the boring ish I deal with on a regular basis. Stocking up on inventory is a sign of optimism. The opposite also holds true. While this varies based upon industry - and recent working capital management practices has really changed the dynamics of this (I think this will eventually be changed in the curriculum) it holds true for smaller widgets companies.
So…building up inventory = optimism
This is directly from the CFA book:
“A report of rising inventories may mean that businesses are very confident of sales and are spending on inventories ahead of expected sales. This would normally be the case in the early stages of an inventory cycle upswing and is bullish for economic growth. But at the late stage of the inventory cycle, a rise in inventories may be involuntary because sales are lower than expected. Such news would be negative.”
In terms of inventory/sales ratio, I think it depends on whether elevated level is by choice: if it’s voluntary due to inventory increase it’s a predictor of growth, and if it’s involuntary due to a decline in sales it’s a predictor of a slowdown.
^ agree 100%
voluntary = growth
involuntary = slowdown is coming
mcap11 - i like the summary