Introduction
In 2021, Target built up its inventory by about $3.2 billion as it stocked up for strong demand and supply chain delays. Buying that stock would normally have used the same amount of cash, but Target had not yet paid for most of it: what it owed suppliers, its accounts payable, rose by $2.6 billion. The net cash cost of the build was only about $0.6 billion. The next year, demand shifted away from the categories Target had stocked. The company marked down goods, cancelled orders and cleared excess stock, steps its fiscal 2022 annual report links to lower profit. Its gross margin rate fell from 28.3% to 23.6%, and its operating cash flow fell by more than half, to $4.0 billion, as earnings dropped and payables unwound.
Inventory transactions are some of the most common in any business, and they illustrate why profit and cash flow follow different timetables. The cost of inventory reaches the income statement only when goods are sold, but the cash for it leaves when suppliers are paid, which can be weeks before or after. Tracing the three stages, buying, selling and writing down, with the method from tracing a transaction through the statements, shows where each effect lands.
Buying Inventory: Balance Sheet First
Buying inventory is not an expense. The goods are an asset until they are sold, so a purchase changes only the balance sheet and, if paid in cash, the cash flow statement. Inventory purchases are an operating cash flow, not an investing one, because inventory is consumed in the ordinary course of business; they appear on the cash flow statement as the change in inventory within working capital, explained in working capital on the cash flow statement.
Most companies buy on credit. Suppose a company receives $100 of inventory from a supplier, to be paid in 60 days:
The income statement is untouched. On the cash flow statement, the inventory increase uses $100 of cash and the payables increase provides $100, so cash does not change. The balance sheet grows on both sides. When the supplier is paid 60 days later, cash and payables both fall by $100, again with no effect on profit. Had the company paid cash on delivery, the trace would show a $100 fall in cash and a $100 rise in inventory, an asset swap with the cash outflow in operating activities.
Costs That Become Part of Inventory
For a manufacturer, "buying" inventory includes making it. Under Accounting Standards Codification (ASC) Topic 330, raw materials, factory wages, freight into the warehouse and an allocation of production overhead, including depreciation of the factory, are all added to the cost of inventory rather than expensed as incurred. Those costs pass through the income statement only when the finished goods are sold. The consequence is that a company producing more than it sells defers part of its fixed overhead into the inventory balance, raising reported profit in the current period while the cash for wages and materials has already gone out. A rising inventory balance alongside improving gross margins is therefore worth a second look: the margin may reflect costs parked on the balance sheet rather than a better business.
- Inventory
Goods held for sale in the ordinary course of business, along with materials and work in progress that will become such goods. Inventory is carried at cost, under a method such as first-in, first-out (FIFO), last-in, first-out (LIFO) or weighted average, or lower if written down, until it is sold, when its cost becomes cost of goods sold.
Selling Inventory: Revenue and Cost of Goods Sold
The sale is where inventory reaches the income statement. Revenue is recognized under ASC 606 when control of the goods passes to the customer, and the cost of the goods sold leaves inventory at the same moment, matched against the revenue it produced. Suppose the company sells goods that cost $60 for $100, on credit, with a 25% tax rate and tax paid in cash:
Net income rises by $30, yet cash falls by $10. The cash flow statement subtracts the $100 of uncollected revenue and adds back the $60 of inventory consumed, leaving the $10 of tax paid as the only cash movement. On the balance sheet, receivables rise $100, inventory falls $60 and cash falls $10, a net $30 increase in assets matched by retained earnings. When the customer pays, cash rises and receivables fall by $100 with no further effect on profit. How gross profit is built from these figures is covered in cost of goods sold and gross profit.
LIFO, FIFO and Cash Taxes
The inventory method decides which costs become cost of goods sold, and when prices are rising it changes cash. Under LIFO, the most recent and most expensive purchases are expensed first, so cost of goods sold is higher, taxable income is lower and cash taxes fall; under FIFO, the older and cheaper costs are expensed first. If LIFO raises cost of goods sold by $10 in a year, pre-tax income falls $10, net income falls $7.50 at a 25% tax rate and cash rises $2.50, the tax saved, while inventory on the balance sheet is $10 lower. Section 472(c) of the Internal Revenue Code allows LIFO for tax only if it is also used in the financial statements, which is why some companies accept lower reported profits to keep the cash benefit. The methods and their effects are compared in inventory costing methods.
Writing Inventory Down
Inventory that has become obsolete, damaged or unsellable at its cost is written down. Under Accounting Standards Update (ASU) 2015-11, inventory measured on FIFO or average cost is carried at the lower of cost and net realizable value, the expected selling price less the costs to complete and sell it; LIFO and the retail inventory method still use the older lower-of-cost-or-market test, as PwC's text of the inventory measurement update sets out. The write-down is usually recorded in cost of goods sold.
On the statements, a write-down follows the non-cash charge pattern. A $40 write-down of stock that is scrapped in the year, so deductible for tax at 25%, reduces net income by $30; the cash flow statement adds the $40 back, either as a separate line or within the change in inventory; cash rises by $10, the tax saved; and inventory falls by $40. Where the goods are still on hand, US tax rules generally allow no deduction until they are sold or scrapped, so the $10 appears as a deferred tax asset rather than cash. The rules for measuring the write-down are in inventory write-downs.
Target's Inventory Cycle, 2021 to 2023
Target's figures, drawn from its fiscal 2023 annual report, show the three stages playing out at scale across three years:
| Line item | 2021 | 2022 | 2023 |
|---|---|---|---|
| Net earnings | 6,946 | 2,780 | 4,138 |
| Change in inventory | (3,249) | 403 | 1,613 |
| Change in accounts payable | 2,628 | (2,237) | (1,216) |
| Cash provided by operating activities | 8,625 | 4,018 | 8,621 |
| Gross margin rate | 28.3% | 23.6% | 26.5% |
Source: Target fiscal 2023 Form 10-K; other operating cash flow lines omitted. Fiscal 2023 had 53 weeks. Year-end inventory was 13,499 in fiscal 2022 and 11,886 in fiscal 2023.
In 2021, the inventory build looked almost free in cash terms, because higher payables offset most of it. In 2022, the reversal hit twice. Markdowns to clear excess stock helped cut the gross margin rate by nearly five percentage points, alongside higher freight costs, and net earnings fell by more than half. At the same time, Target cancelled orders and received fewer goods, so payables fell by $2.2 billion while inventory fell only slightly; the supplier financing that had carried the build disappeared. In 2023, inventory fell by $1.6 billion, releasing cash, and operating cash flow recovered to $8.6 billion even though earnings were still below their 2021 level.
What Bankers Watch
Inventory is one of the clearest early-warning signals in a set of accounts. Bankers compare its growth with sales growth, since stock rising much faster than sales often precedes markdowns and write-downs, and track days inventory outstanding (DIO) alongside days payables outstanding (DPO) to see how much of the inventory is financed by suppliers. Those ratios, with days sales outstanding (DSO), are explained in DSO, DIO and DPO.
In acquisitions, inventory is a central part of the net working capital the buyer expects to receive at closing. A seller that runs inventory down before a sale can flatter its cash generation, and one that builds it up can absorb the buyer's cash after closing, which is why purchase agreements set a working capital target, a mechanism covered in the blog's guide to net working capital adjustments in mergers and acquisitions. In every case, the trace is the same: buying inventory moves the balance sheet, selling it moves profit, and the timing of payments to suppliers decides when the cash actually changes hands.
