“Cash flow problems are some of the most common difficulties small businesses encounter,” says Entrepreneur, “and they are usually the first signs of serious financial trouble ahead. Tying money up in inventory can severely damage a small company’s cash flow.”
That’s why it’s crucial to have a smart inventory management strategy in place to ensure that you’re maximizing operational efficiency and having a positive impact on your profit levels.
What is Inventory, anyway?
“Inventory represents one of the most important assets of a business,” says Investopedia, “because the turnover of inventory represents one of the primary sources of revenue generation and subsequent earnings for the company’s shareholders.”
“Inventory refers to assets that are intended for sale or are in the process of being manufactured for sale. The relationship between inventory and cash is largely determined by your choice of inventory accounting method, the level of inventory you choose to stock, inventory cost and the saleability of your stocks. Efficient inventory management can boost your cash flow, while poor management can cause cash flow problems.”
Accounting For Inventory
The accounting method you use to determine the costs of inventory will directly affect your cash flow. As per Investopedia, there are three common methods for inventory accountability costs:
- Average cost
- LIFO (last-in, first-out)
- FIFO (first-in, first-out)
Businesses in the United States operate under the GAAP, or generally accepted accounting principles, allowing for all three methods to be used. Accounting Standards Code 330-10-30-9 (under GAAP) specifies that companies should focus on the accounting method that best reflects periodic income, which provides businesses with the flexibility to maximize after-tax revenues based on inventory costs.
What Do Stock Levels Have to Do With It?
Stock level refers to the quantity of inventory you retain on site for the purpose of sales. Keeping more inventory on hand than what is truly necessary for current sales means you have to withdraw cash from the bank to pay for the extra inventory. This diminishes your available cash and turns it into non-cash assets.
If you have limited cash flow, tying up funds in inventory you don’t need has negative effects on expenditures. On the other hand, lacking the inventory necessary to make sales means risking potential revenue and profits. Additionally, overstocking inventory results in warehouse expenses such as labor and space.
Net Sales – Cost of Goods = Gross Profits
Cost of goods sold represents the purchase price (or production cost) of inventory. What you paid for the goods you intend to sell affects the amount of cash that will be left in your bank accounts.
By implementing labor-saving technology, ordering low-cost raw materials, and reducing unnecessary overhead, you can lower production cost of inventory. Cheaper-priced suppliers and lower delivery costs are also good ways to reduce inventory purchase cost. By finding ways to save cash by lowering merchandise costs, you’ll increase gross profits and keep more money in the bank.
Inventory Type Affects Saleability
The type of inventory you choose to purchase can significantly affect its saleability. Saleability refers to the rate at which your inventory moves or turns over. Put simply, the more saleable your products are, the faster they move in and out of your store and/or stockroom. The more fast-moving goods you have, the more cash you’ll take in.
“Inventory turnover, or the number of times inventory is sold over a given period, affects profitability. Keeping stocks that are obsolete and have a low turnover slows down sales. Keeping stocks that are having a high demand boosts sales levels. Inventory levels should consider demand levels to avoid overstocking and under stocking.”
“While inventory can be used to your advantage, says azcentral … [I]gnorance about how inventory management can affect the movement of cash into or out of your company will definitely be a disadvantage to your business.”
According to Chron, how you source and manage inventory can impact the different profit levels of your income statement. Poor inventory management prevents your business from maximizing operational efficiency and enjoying a healthy bottom line.