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+.