The Relationships Among Inventory Volatility, Profitability, and Capital Structure

The seminal work of Lee et al. (1997) shows that variability in orders may be larger than that of sales and that this variability increases upstream of a supply chain. An implication of this observation is that variability of inventory should also increase in the upstream direction. The empirical observations of this paper are that this effect on inventory is also associated with profitability and the capital or debt structure of a firm. This relationship is explained by a model of capital structure in which the capacity of a firm is determined by an analog of the news vendor model. The model predicts a U-shaped relationship between inventory volatility and firm profitability and debt-to-equity ratios. The empirical results described in this paper confirm this finding in showing how inventory has highest volatility for firms at the extremes in terms of profitability.