Understanding Financial Statements

Inventory

Inventory consists of the goods and materials a company purchases to resell at a profit. In the process, sales and receivables are generated. The company purchases

raw material inventory that is processed (aka work-in-process inventory) to be sold as finished goods inventory. For a company that sells a product, inventory is often the first use of cash. Purchasing inventory to be sold at a profit is the first step in the profit-making cycle (operating cycle), as illustrated previously. Selling inventory does not bring cash back into the company — it creates a receivable. Only after a time lag equal to the receivable's collection period will cash return to the company. Thus, it's very important that the level of inventory be well managed, so that the business does not keep too much cash tied up in inventory. This will reduce profits. At the same time, a company must keep sufficient inventory on hand to prevent stockouts (having nothing to sell), because this too will erode profits, and may result in the loss of customers.