Why Cash is Always King – Part III

Continuing on from Part II of ‘Why Cash is Always King’, let’s discuss what is referred to as ‘obsolete’ or ‘unsalable’ inventory.

Using the ‘inventory turns’ method of analysis, hopefully you have some idea of how you are doing. Buying inventory sometimes presents significant challenges, especially if you are in a highly volatile market. Volatile markets are often a challenge for companies that buy and sell commodities. For instance, a wholesaler providing milk and eggs to grocery stores faces prices changing every day. Sometimes those changes can be significant. National drug store chains sell gallons of milk as loss leaders. The small grocery down the road, they’re probably selling on the high side of the milk market. But no one wants to be left with unsold milk and eggs at the end of the day. Knowing how much to buy each day or each time can be key to reducing losses related to unsalable inventory (outdated milk and eggs).

Let’s look at a more common small to medium size business challenge. For instance, let’s say you are the Controller at ‘My Doll Shop’. Last year, Doll ‘X’ was a very sought after item and purchasing couldn’t even secure all the inventory you needed. However, a few weeks after Christmas purchasing had the opportunity to buy up a significant number of Doll ‘X’. But this year, little girls have their hearts set on ‘Doll ‘Y’. No one is interested in last year’s big hit, Doll ‘X’. My Doll Company is now the proud owner of some obsolete or slow moving inventory. One good thing about dolls, they are not perishable. They won’t rot on the shelves. But, you have dollars locked up in those dolls. Too many owners and managers simply ignore the problem because they have much more pressing issues to deal with. But if that obsolete and slow moving inventory isn’t dealt with, it takes up space. And, if the company is waiting for the Doll ‘X’ rage to come around again, they are probably in denial.

First, someone in your company, if not you, should have the task of addressing obsolete inventory and how to move it. Can it be sold on E-Bay? There’s work involved but E-Bay gets you a worldwide audience. Could you have a really big sale? I don’t have all the answers to this problem but ignoring it will certainly translate into losses at some point. Manage your inventory every day!

Oh, by the way, if you are the newly hired controller, and you’re working for a company that carries inventory, one of your first objectives should be to familiarize yourself with the inventory and, I would also recommend that at the end of the next accounting period (hopefully at the end of the month) you make sure that a physical inventory is scheduled. Once the inventory is completed, it should be compared with the book inventory to determine any gains or losses. And, very importantly, find out how much of that inventory is obsolete or unsalable. It’s far too often a neglected area of the company’s working capital investments.

In Part IV, the final post on CASH, we will look at FIXED ASSETS and the perils of both spending too much or too little.

Questions? Please feel free to comment, ask questions, or suggest other topics.

Why Cash Is Always King – Part II

As we move further into Cash Flow management, remember that I am talking about ways that owners and managers should approach cash flow management and understand how ignoring it can create liquidity problems that no business wants to deal with. As an owner or manager, Cash Flow is probably one of your biggest challenges.  Many a business has floundered and/or failed as the result of a shortage of cash to meet its obligations.

Every few years, a new business concept or word finds its way into articles and speeches.  ‘Paradigm’ was a big buzzword in the nineties.  We’ve heard the terms ‘thinking outside the box’ (see the latest Quinta Inn commercial).  But one concept we don’t hear as much about as we once did is ‘JIT’ or ‘Just in Time’ where inventory is not purchased until as close to the time it will be needed.  Not every business can operate in this manner but certainly it does have its merits.  If you are buying closer to the time you need it (and not too late) you reduce the carrying cost (the interest on the money you borrowed to finance the inventory) and the risk that the inventory may become obsolete or damaged.  The concept of Just In Time inventory is one that every purchaser of inventory should bear in mind.

In Part II, we will explore simple ways for owners to avoid letting unsold inventory become a drag on earnings. If you are a cash and carry business, you still have to be aware on an almost daily basis how much inventory you are sitting on. But first, assuming you’ve been in business for at least two or three years, you need to understand the concept of Inventory Turns and how to come up with that number from your business financial statements. Your accountant can help you out if you are not sure how to put the numbers together. Below is an example:

  • From your year end Balance Sheet go to the ‘Current Assets’ section.  You should see two columns indicating Current Year’ and ‘Prior Year’ or ‘2012’ and ‘2011’(for example).  If your inventory is divided up into different types of inventory, in each column add those numbers together..  The inventory balance shown in the prior year figure will be your OPENING INVENTORY and the inventory balance shown in the current year should be your ENDING INVENTORY.  Add those 2 numbers together and divide by 2.  You now have your Average Inventory figure for the current year.
  • From your year end Income Statement find your ‘Cost of Goods Sold’ number (If you are strictly a service company, this exercise does not apply to you).

The calculation looks like this:    Cost of Goods Sold/Average Inventory (/ ‘ division))

Where Cost of Goods Sold = $800,000/$400,000 (Average Inventory) = 2

The number ‘2’ essentially means how many times you completely turned your inventory.  But that number must be compared with something.  Generally, there are industry standards you can find to compare your number.  Try googling for this information.  However, according to some sources, inventory turns for manufacturing companies rests somewhere around 6 times per year.  Grocery stores, however, often aim for 12 times.  A high end jewelry store may average as little as 3 to 4 times a year.  In the luxury item business, each sale has the prospect of much greater gross margin dollars.

In addition, if you have enough prior year data, you should be comparing each current year number to the prior year(s).  This will tell you if you are trending towards or away from better cash flow.

Why does the Inventory Turn number matter so much?  Let’s say you have a Line of Credit with a maximum of $500,000.00.  You have invested $300,000 of that line in inventory which now sits in your warehouse.  Is all of that inventory salable right now?  Let’s say you have only one product – Halloween costumes.  In May you find a great bargain on costumes so you use up $300,000 of your Line of Credit to purchase them.  Let’s face it, months must pass before you can turn that inventory into a sale.  Your money is stuck in that ‘pit’ I referred to in my first article on cash flow.  Maybe you have to turn to a higher cost source of money to make it until Halloween to meet payroll, utilities, rent, etc.  How much money are you really going to make on that bargain?

I am not at all discouraging you from taking advantage of good buying opportunities.  But you have to think ahead.  Maybe you should have invested only $150,000 in costumes.

Hopefully whatever system you are using, you can run inventory reports that tells you how much you have on hand at any given time.  Many systems offer lots of ways to track and manage inventory.

In Part III I’ll talk about ‘SLOW MOVING INVENTORY’ and ‘OBSOLETE/UNSALABLE’ inventory.  Get those calculators out and start figuring out what your inventory turns grade is.  I hope it’s an A+.

JDS

Why Cash is always King – Part I

ProfitHaving worked most of my career in the agribusiness field, I have found the ‘Limiting Factor’ theory applicable to many areas of business.  The ‘Limiting Factor’ is a simple concept.  A plant needs many different types of nutrients (food) to grow.  You can supply all the nutrients it needs, except one.  Without that one, the plant cannot grow, in spite of everything else having been done correctly.  So all the other things you did right, they do not count!  The same with cash.  No money, nothing else really matters.

Even large businesses struggle with Working Capital needs

If the entrepreneur is the heart of the business, cash is the blood.   Lack of working capital is not just a start-up issue.  It confronts owners everyday, in spite of our low interest rate environment.  Where are the money ‘pits’ that working capital is usually trapped?

  • Inventory
  • Accounts Receivable
  • Fixed Assets

The pits mentioned above are, by no means, all of them but are generally the largest ones.  In future posts, I’ll talk about how a business can do a better job of managing their liquidity.  Ask yourself, is your banking arrangement facilitating your ability to grow your business, meet payment deadlines and invest in the future?  Just because you’ve done business with them for the last ten or twenty years does not mean you should be comfortable.  Do you have just one lender?  Should you?

The Cash Conversion Cycle

Simply put, the Cash Conversion Cycle is a measurement of how long it takes to convert the dollar invested into inventory back into cash.  Accounts payables affects the ratio as well.  You can probably find a more detailed explanation by googling it.  Many business owners understand that money tied up in Accounts receivables and inventory must be freed up as quickly as possible to continue financing the business.  Obsolete or damaged inventory takes up space and is no longer worth its original cost.  Accounts Receivables moving well past terms are problematic and may indicate you won’t be turning the receivable into cash as soon as you had expected.  A/R and Inventory are areas that owners and managers must be vigilant about.  Fixed Assets present a somewhat different issue.  There are really two types of assets – those that can directly produce income and those that do not.  For instance, a new (or used) delivery truck in addition to the one you have is an expansion.  If the truck has been added to service new accounts, and generate new or additional business, then that asset has income producing properties.  However,a fancier car for a manager or owner rarely translates into additional, measurable  income for the company.  Unless the company can clearly afford such a fixed asset investment, non-income producing asset expenditures should be avoided.

Unless your company is rolling in money, paying attention to cash flow should be a top priority.  More on this subject in future posts.

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