Working capital is an important measure of a company’s financial health. It’s defined as the difference between Current Assets and Current Liabilities (Working Capital = Current Assets – Current Liabilities). When a company has positive working capital, it is able to pay off its short-term liabilities from assets that can be quickly converted to cash.
Inventory is a part of current assets and therefore has a direct impact on working capital levels. Because of its impact on working capital and for many other reasons, ensuring that inventory is managed properly is critical for business success.
Costs Related to Inventory
Carrying inventory has many costs associated with it. These can be organized into the following categories:
Inventory Ordering Costs
These are the costs associated with inventory orders placed by your company. They include paperwork processing costs, handling, freight and in some cases setup costs for machinery.
Inventory Carrying Costs
These are the costs associated with holding inventory and include warehousing, insurance and the financing costs associated with funds used to purchase the inventory. If your company draws down $500,000 on a line of credit to purchase the most recent order of inventory, the interest costs on that “draw down” are part of inventory carrying costs.
Inventory Stock-out Costs
These are the costs – both real costs and opportunity costs – of not having sufficient inventory on hand. These include lost sales, costs associated with placing backorders and substitution costs.
Focus on the Goal
In a perfect world, you would know exactly how many units of inventory your business would sell on a given day and each unit would arrive instantly before the customer came to buy it. This scenario would all you to sell as much inventory as possible while minimizing the inventory carrying costs. Maximum sales and minimum costs yield high profits. Since we don’t live in a perfect world, we have to do the best we can, balancing the need for having sufficient inventory in stock to avoid stock-out costs while at the same time minimizing carrying costs.
How Do You Know if You are Doing a Good Job?
There are three ratios that provide insight into your company’s inventory management. Let’s assume a sample company over the last 12 months has:
- Cost of Goods Sold of $5 million
- Beginning inventory of $1 million
- Ending inventory of $500,000
- Average collection period of 45 days
Average Inventory Turnover = Cost of Goods Sold / [(Beginning Inventory + Ending Inventory) / 2]
Average Inventory Turnover = $5,000,000 / [($1,000,000 + $500,000) / 2] = 6.67 times per year
Average Inventory Turnover measures the number of times per year that your company’s inventory is replaced or “turned over” using cost of goods sold as the basis. A higher Average Inventory Turnover is attractive because it generally means that your company is not tying up resources unnecessarily in inventory carrying costs. However if it gets too high, it could mean that you aren’t carrying sufficient inventory and you could incur lost sales and other inventory stock-out costs.
Ratio #2: Average Days Inventory on Hand
Average days Inventory on Hand = [(Beginning Inventory + Ending Inventory) / 2] / (Cost of Goods Sold / 365 days)
Average Days Inventory on Hand =[($1,000,000 + $500,000) / 2] / ($5,000,000 / 365) =54.75 days
This measures the number of days, on average, that it takes to sell a company’s entire inventory on hand based on the cost of goods sold. The process of selling the entire inventory on hand is also known as “turning over” your inventory. If your average days inventory on hand is too high, this means that your company is most likely buying too much inventory. This increases the inventory carrying costs, which hurts your profitability and ties up too much cash in inventory. Having a lower Average Days Inventory on Hand is usually a good sign of inventory management. But you should be careful because if it is too low this may indicate you are not buying sufficient inventory and you could be incurring inventory stock out costs.
Ratio #3: Average Inventory Conversion Period
Average Inventory Conversion Period = Average Days Inventory on Hand + Average Collection Period
Average Inventory Conversion Period =54.75 days + 45 days = 99.75 days
The Average Inventory Conversion Period is the amount of time, on average, that it takes a company to go from purchasing inventory, to selling that inventory, to getting paid by the customer on the sale. This is a very important measure of your company’s performance because it captures both your inventory management ability and your accounts receivables management in a single ratio. The goal is to have a short average inventory conversion period. The shorter it is, the faster you are able to convert inventory into paid sales.
How Important is Inventory Management to You?
A recent article in Bloomberg Business week profiles Quidsi, the company behind Diapers.com and Soap.com whose co-founder Marc Lore has been interviewed on OPEN Forum. The company has been a member of OPEN since 2005. One of the most important reasons for their success is effective inventory management. They use a combination of complex algorithms to be as precise as possible.
How does your company manage inventory? What are some of the important challenges you face? Let me know in the comments below or via email!
Mike Periu is the founder of EcoFin Media, LLC an independent producer of financial, economic and entrepreneurial content for television, radio, print and the internet. Over the past ten years he has started three companies and advised over 50 companies on financial strategies including fundraising. Mike also hosts regular small business webinars on a range of topics relevant to business owners.