There is a positive correlation between the quality of a company’s inventory control and its financial performance. Many financial ratios incorporate inventory values to measure aspects of a business’ financial health. For example:
- Inventory turnover ratio helps a business to plan and to more accurately forecast the cash necessary to reinvest in inventory stock based on past sales performance. It also helps to identify any underperforming product lines that are tying up cash and taking up space. Identifying these slow-moving products means you can reduce order quantities or discontinue entirely and replace with better-performing products.
- The average days to sell ratio is a measure of the time it takes a company to buy or create inventory stock and convert it into a sale. It alerts business owners to the average length of time, in days, it takes to sell each inventory item. The importance of this ratio is based on the ‘time is money’ adage and the opportunity costs of tying up capital in holding inventory stock.
- Holding costs are incurred storing and maintaining inventory stock and include such costs as insurance, warehousing, security and any associated equipment and labour costs. They are an important cost to monitor when making inventory decisions.
Key performance indicators
Many KPIs relate to the movement of inventory stock, such as fulfilment cycle time, order accuracy, on-time delivery and cost per order. When businesses fail to track and measure performance, they fail to identify problems. It is difficult to manage inventory levels if you don’t know how quickly inventory stock is moving through your organisation. By failing to track fill rates it is impossible to know how well you are meeting customer needs.
Monitoring and understanding inventory ratios enhance overall inventory control, improving the company’s performance and profitability. Take, for example, companies like Dell and Toyota who are considered leaders in the area of total quality management. Utilising inventory control practices such as just-in-time processes, zero waste and lean management, has in turn been credited with making these companies market leaders in their respective fields.
The effect of inventory control on financial statements
Poor inventory control has a cascading effect on financial reporting. Errors in calculating inventory will impact the costs of goods sold (COGS) and income and profit results.
Inventory costing can directly affect cashflow because a business using LIFO will have higher COGS and would be more representative of the current economic situation. Reported revenue and will therefore be more accurate, providing a better indicator for forecasting. If, however, a business uses FIFO when prices and inventories are both rising, COGS would be low with a higher net income, resulting in higher taxes and lower cashflow.
Inventory control has a big impact on the inventory line item of the balance sheet. The inventory line item not only reflects the cost of inventory but also any costs directly or indirectly incurred to prepare an item for sale. These costs include the initial purchase price of that item as well as freight, inwards goods receipt, storage, maintenance, insurance, taxes and any other associated costs.
Any changes to inventory or incorrectly recorded balances will result in the value of assets and the owner’s equity being incorrectly reported on the balance sheet. It is important, therefore, to optimise inventory control to ensure that the inventory reported on your financial statements is accurate, giving a true representation of your financial health for decision-making, reporting and taxation purposes.