How you manage your inventory will directly impact the cashflow of your small business and when you fail to effectively manage stock you are putting your business at a disadvantage. Why? Because your cash is tied up in that very stock.
The correlation between inventory control and cashflow is largely determined by the levels of inventory stock you hold, your inventory turnover and your choice of inventory accounting method.
Effective inventory control can boost your cashflow, in the same way that bad stock management will lead to additional costs and even cause cashflow problems.
Holding inventory is unavoidable. However, holding too much inventory stock ties up cash that could be invested in other areas of the business. In addition to the initial cost of stock, you also bear the ongoing costs of holding that stock and maintaining it in a saleable condition.
Conversely, if you fail to have enough on-hand inventory then you risk stock-outs that lead to lost sales, reduced customer satisfaction and the potential loss of future sales. In either of these situations, revenue and profitability can decrease and cashflow will be affected so you need to achieve good inventory control to get the balance right.
Cashflow and inventory control
One of the best ways to improve cashflow and profitability is through inventory control. Inventory generates cashflow but purchasing inventory requires a cash outlay that affects the company’s cash balance.
An increase in inventory stock will appear as a negative amount in the cashflow statement, indicating a cash outlay, or that a business has purchased more goods than it has sold. If, on the other hand, inventory stock has decreased, the reduction in inventory stock would be shown as a positive amount on the cashflow statement.
The cashflow your business generates is largely dependent on how you source and manage inventory. Holding more inventory than what is needed for current sales forecast and demand means using available cash to pay for the surplus inventory and converting current cash into non-cash assets.
Inventory turnover is a key measure of how well a business is doing, the inventory turnover ratio determines the number of times inventory stock is brought and sold within the company’s financial year.
Inventory turnover improves business cashflow when items are ‘turning over’ and not sitting unsold on the shelves. High turnover implies strong sales and requires increasingly efficient inventory control to meet this high demand and respond to market needs.
There are two ways of calculating your inventory turnover ratio. The first is using the cost of goods sold (COGS), generally seen as a more accurate measure of profitability because it includes any carrying cost of goods sold, in addition to the purchase price.
The COGS are subtracted from sales revenue to ascertain the businesses gross margins: (beginning inventory + inventory purchases) – end inventory
The second method simply adds the beginning inventory for the period to the end inventory for the period and divides by two: (beginning inventory + end inventory)/2
The higher your inventory turnover ratio, the greater your cashflow. If the ratio is low, however, you are buying more inventory faster than you’re selling it and don’t have good inventory control.
Improving inventory turnover through proper inventory control will help reduce the COGS, positively impacting cashflow and resulting in more cash in the bank.
Inventory accounting methods
There are three main accounting methods used to determine the cost of inventory and the one chosen will directly affect the business’ cashflow. They are the FIFO method, the LIFO method, and the weighted average method. Unleashed Software uses the weighted average method.
The weighted average method all the costs are added together, then divided by the total number of units to derive a weighted average cost. This is adjusted each time more inventory is purchased.
Improve cashflow with inventory control
There is a direct link between a business’ cashflow and inventory stock, with inventory affecting cashflow in either a positive or negative way. How you manage your inventory, optimise turnover and account for stock will directly influence cashflow and profitability.Topics: inventory accounting, inventory control, inventory reporting