What to do about inventory write-downs?

Amanda’s question:

I am looking at four years of company-prepared financial statements that report an adjustment to inventory each year. The adjustments are approximately $60k, $220k, $412k, and $605k from the oldest to the most recent years. When completing spreads, we worked this adjustment into COGS as presented on the financial statements. The account officer is asking us to add those items back to cash available to service debt each year. Is this reasonable?

Linda says:

My initial reaction is YIKES! Why all the write-downs? First, let me address the simplifying assumption we make about COGS in general that does not dove-tail precisely with timing of cash outflow. Then I’ll run down the write-down of inventory and the questions I’d ask about this particular deal.

COGS Simplifying Assumptions

We make a simplifying assumption that COGS is cash flow out during the year, but that is not true. There is always beginning inventory and ending inventory. Only if inventory levels are steady beginning and end does that simplifying assumption hold water. So it is always true that noticing significant increases or decreases in inventory balances can give you a different view of the cash-flow impact of COGS.

Inventory Write-Downs

Inventory is typically written down for two reasons:

    1. Inventory has become obsolete

When they cannot sell inventory, they have to write it down. Otherwise inventory will be artificially high, and the profitability won’t reflect the loss.

    1. Inventory has lost value

If the inventory can be bought today for substantially less than what it cost when purchased, the write-down is necessary to reflect that loss in value.

Generally you will see the adjustment/write-down either in COGS, if relatively small, or as an income statement operating expense if larger. Your account officer could be on the right track, if it were not for the escalating amounts.

How could an inventory write-down be ‘non-cash’?

If the inventory was purchased (and therefore the cash spent) in a year prior to the years in your analysis, then the actual excess out-of-pocket cash happened in the past. The recognition of the write-down after the fact does not reflect cash outflow in the years being analyzed. I could actually be talked into that approach for a one-off adjustment.

But increasing amounts over the four years makes me wonder. If this represents obsolete inventory write-downs, does it call into question the management capability to guess right on amounts to pay for inventory items? If it is write-downs because inventory ‘values’ have been plummeting, what is the long-term prospects for this business?

On still another hand (are we up to more than two, yet?), look at what years are covered. What kind of business is this? Is it in an industry where, industry-wide, they were getting hit and hit hard during the recession? If so, have things improved?

I’d love to see what was happening to revenues over that same period of time. Perhaps this company could handle the escalating write-offs because they were in a strong liquidity position to start with.

Analysis often raises questions

So you see, this brings up questions in my mind. Your account officer needs to make the case that it is non-cash or non-recurring for you to add it back. Perhaps s/he can.

Update from Amanda

Your first reaction is right on target with ours. The company is a custom auto shop. They specialize in customizing Jeep Wranglers. We were told that the write-downs were for obsolete inventory and reductions in values. Revenue trends are positive.

Cash flow was a different story. The write-downs appeared as an expense and EBIDA was negative for the most recent year. The good news is that our loan is completely secured by a perfected assignment of liquid collateral. It was an interesting case and one that I had not seen before. And the financial statements are prepared by the company and not an accountant.

Linda’s follow-up

Amanda sent me some numbers with her update. COGS as a % of sales was creeping up when I saw the numbers. I’d be interested in industry averages, if they are available. It looks like Amanda’s team has great collateral and a still profitable business if they get the write-downs under control. Adding industry information to the mix could only strengthen the write-up if needed.

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