The biggest problem with inventory

Cash is the oxygen of a business and is absolutely necessary for growth because cash-starved businesses will always have to make the tradeoff of short term solvency for long term growth. If you manage a business, you need to focus on cash just as much (and possibly more) than you focus on profit.

I can remember a time back in the recession of 2008 when our business was totally out of cash. In fact, I was not only out of cash but I had maxed out virtually every credit opportunity available to us. Every day, I logged in to online banking, hoping that enough money had been deposited to cover payroll and our inventory needs. It took years to crawl out of that hole and I have never forgotten it. So I get the pain of low cash flow, both on a personal/emotional level as well as on a business level. By the way, I also changed my habits; we have operated virtually debt free ever since.

One of the great ironies of business is that you can be strapped for cash even while wildly successful. This is especially true if you have inventory and are growing fast. Let me give you an example. Let’s say that you keep two months of inventory on your shelf and you are selling $100,000/month. Also, let’s say you have a healthy 20% net margin. In this scenario, you have $200,000 in inventory and have a net profit of $20,000/month.

Now, let’s say that your business is growing 10% per month. That means that next month, you are going to do $110,000 in sales and need $220,000 in inventory and you are going to net $22,000.

Think about that for a moment. You just increased your inventory by $20,000 and need to come up with that money. Your increased profits are not going to cover that $20,000 because your increased profit is only $2,000. In effect, you have to come up with $18,000 in cash to cover that growth.

See the problem? Growing fast with an inventory business sucks up cash. Run the same numbers with 20% growth and you will see that things get out of control very rapidly.

There are several ways to manage this cash problem. Here are the two main ones:

  • Negotiate terms. If you keep 60 days on the shelf and get 60 day terms with your supplier, you really have no cash invested in inventory at all because all the inventory on the shelf will be gone before you have to pay for it. Or, if you get 30 day terms, you really only need cash for half of your inventory on the shelf. Negotiating terms is difficult for newer companies and impossible in some industries but if you can get terms, you should.
  • Improve efficiency. If you can order smarter and with precision, you can possibly reduce the number of days on the shelf. For example, if you could use historical data to better predict sales and reduce your inventory from 60 days to 45 days, you just cut your cash needs by 25%. We use inventory software for this kind of analysis.

There is almost always a tradeoff between efficiency and profits. For example, you sometimes might get discounts based on volume purchases. Discounts raise your gross margin but increase your cash needs. If you have cash and can afford to be a bit less efficient, you can take advantage of such discounts. If you are tight for cash, you cannot.

Note that in that previous example, having plenty of cash has a direct impact on profit. As I mentioned at the start of this article, limited cash means a tradeoff between solvency and profit. If you have plenty of cash, you can have both and by the way, you will enjoy business a whole lot better too.

Like all aspects of business, you need to keep track of your ROI on your inventory. Your inventory ROI is simply your net profit divided by the inventory that drives that profit. In the next blog post, I am going to discuss what acceptable ROI on inventory might be for a typical inventory business.

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