Wal-Mart's Mastery: Analyst's Toolkit

BOSTON (TheStreet) -- Inventory management is a sleepy topic typically given little credit for its effect on a business. But with Black Friday a few days away and a potentially grim shopping season ahead, retailers are trying to offer enough must-have products without creating an overstock that wastes space and earns nothing.

Now that the holidays are here and Black Friday looms, inventory will be a key topic in the coming weeks. While most stores may struggle to keep hot deals on the shelf during the shopping rush from Black Friday and beyond, Wal-Mart's(WMT Quote) superior supply-chain management will allow it to better satisfy customers' shopping needs.

As the biggest sellers for the shopping season sell out, most likely HDTVs and video-game systems like the Wii and Xbox, a store with active management will have a steady stream of new products arriving daily to replenish shelves, while stores that have weaker inventory management will most like have a large hoard waiting on Black Friday and miss out on a sales bonanza.

For companies like Wal-Mart or Target(TGT Quote), which have $39.6 billion and $9.2 billion in inventory, respectively, at any given time, inventory management is crucial to maximizing profitability since it can free up cash for investment and reduce exposure to adverse events related to inventory, such as obsolescence.

Comparing inventory turnover and so-called days inventory on hand can help discern which companies are managing inventory levels responsibly and which are losing out by failing to wring out the most money they can.

The theory behind inventory turnover is simple. The cost of goods sold for the year should be the aggregate inventory cost for sales made. If that number is divided by the average inventory over the period, we can determine how many times inventory cycled through in the period. More cycles mean the company is holding less in inventory at any one time in relation to sales. The less a company can hold in inventory while still not missing out on sales, the more cash it frees up to invest in growth or to return to its investors.

Taking that a step further, by dividing the number of days in the period by the number of inventory cycles, we can see the average length of time a product sits on the shelf before it's purchased. The less time on the shelf, the better.