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The Relationship between Inventory and Financial Performance: An Analysis

of a Sector

Conference Paper · January 2013

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Mehmet Fatih Buğan Yunus Kılıç

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 International Conference on Economic and Social Studies (ICESoS` 13)
"Economic Crises and European Union"

The Relationship between Inventory and Financial Performance: An Analysis of a

Sector

Co-author:
Ata, H. Ali, Assoc. Prof., University of Gaziantep, Gaziantep, Turkey,
ata@gantep.edu.tr

Contact author:
Buğan, M. Fatih, Research Assistant, University of Gaziantep, Gaziantep, Turkey,
mfbugan@gantep.edu.tr

Co-author:
Kılıç, Yunus, Research Assistant, University of Gaziantep, Gaziantep, Turkey,
ykilic@gantep.edu.tr

Abstract: The purpose of this study is to investigate the relationship between inventory and
financial performance for manufacturing firms in Turkey. In this respect, financial statements
of manufacturing firms between 2005 and 2011 were used. Financial data was obtained from
the Istanbul Stock Exchange database. Raw material, work-in-process, finished goods and
total inventory were taken as indicators of inventory performance. Afterwards, the ratios of
these indicators to total sales are used in analysis. Operating profit to total sales was used as
an indicator of financial performance. Regression analysis was employed using financial
ratios obtained from the financial statements of firms within the scope of analysis. This study
is of vital importance because of several reasons. Only a limited number of studies relevant to
the discrete components of inventory performance and financial performance have been
conducted in Turkey. This study is relevant to both inventory and finance departments of
firms. Cost of inventory and financing of the investment of these assets are important for
financial managers. As a result, a negative correlation was found between ‘finished goods
inventories to sales’ ratio and operating income margin.

Keywords: Operating performance, inventory performance, financial performance, raw

materials, work-in-process, finished goods.
 International Conference on Economic and Social Studies (ICESoS` 13)
"Economic Crises and European Union"
I. Introduction

Inventories, which are among working capital factors and have the smallest amount of
liquidity, have an important effect on the financial performance of enterprises, especially in
terms of productivity. Inventory management and the determination of optimal inventory
level play important roles in terms of the productivity of firms’ operations especially for the
firms which operate in the manufacturing industry.

A decrease tendency in the ratio of inventories to sales has been observed in the recent years,
generally in developed countries. The development of inventory control methods, the use of
computers in the control of inventory, the development and acceleration of transportation
technologies, the utilization of new systems of stockpiling, and the incentive for loan sales has
caused this decrease. In our country, it has also been observed that the ratio of inventories to
both assets and sales has decreased (Akgüç, 2010).

Effective management of assets provides an important competitive power to companies. The

obtaining and holding of inventories with minimum cost also significantly contributes to
profitability (Kiracı, 2009).

Inventory management is a significant factor that affects the operating profitability of

enterprises. A number of studies exist in the literature, illustrating the fact that inventory
management is influential on the financial performance of enterprises (Capkun et al., 2009;
Eroglu and Hofer, 2011; Husona and Nanda, 1995).

Enterprises can reduce the time allocated for the process from raw material to finished goods,
can decrease the amount of inventories in their warehouses (Cannon, 2008) or can lessen the
waste time in the production process (Capkun et al., 2009).

The detection of whether the investment in inventories amount for an optimum cost for a
company requires the balancing of the costs and risks of holding inventories with the benefits
it will provide. Having created a balance between the additional benefit of holding inventories
and the costs it will bring about, maintaining investment in inventories produces adverse
effects on the profitability of the firm.

We can state the contribution of the present study to the literature as follows: In this study, the
effects of raw material inventories, work-in-process inventories and finished goods
inventories on financial performance have been evaluated separately for companies listed in
the Istanbul Stock Exchange operating in the sectors of basic metal industries and fabricated
metal products, machinery and equipment.

II. Literature Review

When the literature is researched, a number of studies can be detected, which analyze the
relationship between inventory management and financial performance (Protopappa-Sieke
and Seifert, 2010; Shah and Shin, 2007; Klingenberg et al., 2010; Shin et al., 2011). However,
only a limited number of studies which dwell on the relationship between raw material
inventories, work-in-process inventories and finished goods inventories with financial
performance exist in the literature.

Several of the studies dealing with the relationship between inventory management and firm
performance have not been able to detect a significant relationship (Vastag and Whybark,
 International Conference on Economic and Social Studies (ICESoS` 13)
"Economic Crises and European Union"
2005; Balakrishnan et al., 1996; Cannon, 2008). Vastag and Whybark (2005) analyzed the
relationship between inventory turnover and performance in their study of 938 manufacturing
companies. The findings of the study did not indicate a significant relationship between
inventory turnover and firm performance.

Cannon (2008) who used return on asset (ROA), return on investment (ROI), market value
added (MVA) and Tobin's Q variables as financial performance indicators, reached the
conclusion that the improvement in inventory performance did not have a significant effect on
MVA and Tobin’s Q, which were firm performance indicators. The findings indicated that the
remaining performance indicators (ROA and ROI) were significantly yet negatively related to
inventory performance. It was also observed that an increase in inventory performance
resulted in a negative effect on overall performance.

In another study conducted on the relationship between inventory turnover and financial
performance, Huson and Nanda (1995) used earnings per share as an indicator or financial
performance. Unlike Vastage and Whybark (2005), they concluded that an improvement in
inventory turnover resulted in a correlated improvement in earnings per share.

Fullerton et al. (2003), looked into the relationship between JIT use and financial performance
of firms using 253 US manufacturing firms as research subjects. While they used total
inventory to net sales as inventory measure, they utilized return on assets and return on sales
as performance measures. The findings of the study showed that an increase in JIT use
resulted in a corresponding improvement in the financial performance of the participating
companies.

Lieberman and Demeester (1997) analyzed the effect of inventory reduction on productivity
growth in Japanese automotive industry. The analyses showed that inventory reduction
increased profitability.

In most of the studies analyzing the relationship between inventory and financial
performance, total inventories have been used as indicators of inventory. In one of the rare
studies dealing with the relationship of raw materials inventories, work-in-process inventories
and finished goods inventories with firm performance, Eroğlu and Hofer (2011) collected
their data from firms operating in US manufacturing industries. As a result the utilization of
Vector Autoregressive and Vector Error Correction Models, the authors found that raw
materials inventories were more effective on firm performance than work-in-process and
finished goods inventories.

Capkun et al. (2009), searching for a relationship between inventory types and financial
performance, detected a statistically significant positive correlation between inventory
performance and financial performance. Gross profit margin and operating profit margin were
used in the study as financial performance indicators. Moreover, significant correlations were
obtained between discrete types of inventory and financial performance. The highest
correlation was found between raw material inventories and financial performance.

III. Data and Methodology

In this section, specifics of data and methodology are going to be elaborated.

 International Conference on Economic and Social Studies (ICESoS` 13)
"Economic Crises and European Union"
Data Collection

The dataset used in this study has been obtained from the Borsa Istanbul database and covers
two industries: Basic Metal Industries and Fabricated Metal Products, Machinery and
Equipment. The financial ratios used in the analysis were obtained from the balance sheets
and income statements of the companies between the years 2005 and 2011. Companies which
did not have regular data between the mentioned years were excluded from the study. As a
result, 28 companies which operate in the sectors of basic metal industries and fabricated
metal products, machinery and equipment were included in the study.

In our study, five independent variables were used as inventory indicators:

!"#(!"#!!! ,!"#! )
i. 𝑅𝑀𝐼𝑆 = !"#$%
(Raw material inventories to sales)  
 
!"#(!"#"!!! ,!"#"! )
ii. 𝑊𝐼𝑃𝐼𝑆 = !"#$%
(Work-in-process inventories to sales)  
 
!"#(!"#!!! ,!"#! )
iii. 𝐹𝐺𝐼𝑆 = !"#$%
(Finished goods to sales)  
 
!"#(!"!!! ,!"! )
iv. 𝑇𝐼𝑆 = !"#$%
(Total inventories to sales)

!"
!!!
v. 𝑂𝐼𝑀1 = !"#$% (Operating income to sales)
!!!

To be consistent with financial performance measures, inventories are scaled by sales.

Operating income margin was used as a financial performance indicator. We can explain the
reason for the use of OIM1 as an independent variable as follows: Only the current operating
income margin was used as a financial performance indicator, whereas the ratio of current and
last year’s average values to sales was used for inventory indicators. To create consistency
between independent variables and the dependent variable, the operating income margin of
the previous year was included as an independent variable.

Research Hypotheses

H01: There is no relationship between ‘raw material inventories to sales’ and financial
performance.

H02: There is no relationship between ‘work-in-process inventories to sales’ and financial

performance.

H03: There is no relationship between ‘finished goods inventories to sales’ and financial
performance.

H04: There is no relationship between ‘total inventories to sales’ and financial performance.

Methodology

To test the relationship between inventory and financial performance, a regression model is
formulated to estimate the performance effects of RMIS, WIPIS, FGIS, TIS, and OIM1.
Equation is specified as:
 International Conference on Economic and Social Studies (ICESoS` 13)
"Economic Crises and European Union"

𝑂𝐼𝑀!" = 𝐶 +   𝛽! 𝑅𝑀𝐼𝑆!" +   𝛽! 𝑊𝐼𝑃𝐼𝑆!" +   𝛽! 𝐹𝐺𝐼𝑆!" +   𝛽! 𝑇𝐼𝑆!" + 𝛽! 𝑂𝐼𝑀1!" +   𝜀!" (1)

where 𝑂𝐼𝑀!" is the operating income margin for firm f in year t;

𝑅𝑀𝐼𝑆!" , 𝑊𝐼𝑃𝐼𝑆!" , 𝐹𝐺𝐼𝑆!" ,  𝑇𝐼𝑆!" ,  and 𝑂𝐼𝑀1!" are the indicators of inventories as independent
variables.

IV. Findings

When the five variables which are inventory indicators were subjected to regression analysis,
a multicollinearity problem occurred due to the high correlations between variables. ‘Total
inventories to sales’ variable was excluded from the study, since it displayed a very high
correlation with the other independent variables.

The findings of the regression analysis are demonstrated in Tables 1, 2 and 3:

Table 1: The results of ANOVA

Model Sum of Squares df Mean Square F Sig.

Regression .433 4 .108 21.717 .000
Residual .783 157 .005
Total 1.217 161

As shown in Table 1, the results of regression analysis is statistically significant (p<.001,

f=21.717).

Table 2: Model Summaryb

R R Square Adjusted R Std. Error of the Durbin-Watson

Square Estimate
.597a .356 .340 .07063250 1.938

a. Predictors: (Constant), OIM1, RMIS, WIPIS, FGIS

b. Dependent Variable: OIM

R Square expresses to what extent the independent variables can explain the alteration in the
dependent variable. In other words, it symbolizes the explanatory power of the model.
According to Table 2, independent variables account for 35.6% of the change in the
dependent variable.

The autocorrelation among regression model residuals have been tested using Durbin-Watson
factors. If Durbin-Watson factors are between 1 and 3, there is no autocorrelation problem
(Alsaeed, 2006). As shown in Table 2, Durbin-Watson factor is 1.938, so there is no
autocorrelation problem in the regression model.
 International Conference on Economic and Social Studies (ICESoS` 13)
"Economic Crises and European Union"
Table 3: Coefficients

Unstandardized Standardized Collinearity Statistics

Coefficients Coefficients
Std.
Model B Error Beta t Sig. Tolerance VIF
(Constant) .059 .011 5.238 .000*
RMIS .064 .084 .083 .757 .450 .339 2.951
WIPIS -.009 .078 -.014 -.121 .904 .302 3.313
FGIS -.253 .067 -.488 -3.791 .000* .247 4.041
OIM1 .314 .069 .306 4.529 .000* .898 1.114

*Variables are significant at the .05 and .01 levels, respectively.

If there are high correlations between independent variables, this condition affects the power
of the model. This situation is termed ‘Multicollinearity problem’ in the literature (Pearce &
Reiter, 1985). Tolerance and Variance Inflation Factor (VIF) has been used to explain the
multicollinearity problem. To prevent the multicollinearity problem, the tolerance value
should be higher than 0.2 and the VIF value should be lower than 10. When the tolerance and
VIF values are analyzed in Table 2, it is observed that the tolerance value for all the variables
is higher than 0.2 and the VIF value for all the variables is lower than 10. It means there is no
multicollinearity problem in the regression models.

To state the equation:

𝑂𝐼𝑀 =   .059𝐶 + .064𝑅𝑀𝐼𝑆 − .009𝑊𝐼𝑃𝐼𝑆 − .253𝐹𝐺𝐼𝑆 +   .314𝑂𝐼𝑀1 (2)

Regression results show that the relationship between FGIS and OIM1 variables and financial
performance is statistically significant. Nevertheless, no statistically significant relationship
was observed between RMIS and WIPIS variables and financial performance. According to
these findings, H01 and H02 hypotheses are accepted, whereas H03 hypothesis is rejected. A
negative correlation has been indicated between finished goods inventories and financial
performance. H04 could not be tested since ‘total inventories to sales’ variable was excluded
from the study due to multicollinearity.

V. Conclusion

This study is an empirical analysis of the relationship between inventories and financial
performance for 28 manufacturing companies listed in Borsa Istanbul. As a result of the
regression analyses conducted on the dataset, a negative correlation between ‘finished goods
inventories to sales’ ratio and operating income margin. Based on this finding, it can be
inferred that companies’ decreasing the amount of their finished goods leads to a positive
change in their profitability. No significant relationship was detected between raw materials
inventories and work-in-process inventories with financial performance. Besides, a positive
correlation was obtained between the companies’ operating income margin for the previous
year and that for the current year.

The results cannot be generalized to all the companies in Borsa Istanbul, since they represent
tendencies for the Basic Metal Industries and Fabricated Metal Products, Machinery and
Equipment Industries and different sectors keep different amounts of inventories. Therefore,
 International Conference on Economic and Social Studies (ICESoS` 13)
"Economic Crises and European Union"
this study should be replicated for different sectors. Furthermore, sampling should be
extended to all sectors if the relationship between discrete types of inventories and financial
performance for Borsa Istanbul as a whole.
 International Conference on Economic and Social Studies (ICESoS` 13)
"Economic Crises and European Union"

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"Economic Crises and European Union"
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