Cash flow and inventory

Cash flow problems destroy businesses. In fact, cash flow problems destroy very profitable businesses. Especially if your business has inventory, an obsession with your cash flow is critical to your survival.

Because the term cash flow is thrown around and used in different ways, let’s talk about what cash flow actually is. Because it is not profits. You may see the term used to refer to company profits plus owner compensation but that is not correct either. A company can have great profits but horrific cash flow.

Cash flow is the measurement of cash flowing in or out of a business. While profit is a key component of cash flow, it is not the only one. Here is a quick example: let’s say a company has an annual profit of $300,000 but over the course of that year, increased its inventory from $100,000 to $200,000.

Assuming no other factors are relevant, the company profit is $300,000 but the cash flow was only $200,000. Why? Because it cost $100,000 to increase the inventory. A simple cash flow report would look like this.

Starting cash $150,000
Cash in:
Profits $300,000
Cash out:
Inventory -$100,000
Ending cash $350,000
Net change $200,000

This is a very simplistic and rosy scenario for an inventory business actually. Moreover, a real inventory business is not nearly this simple, and often, the cash flow is not nearly this healthy either. You will often find that cash flow and inventory are like oil and water. In fact, profitability and cash flow quite often seem determined to not play well together.

Why fast-growing inventory businesses struggle with cash flow

Fast-growing businesses put a lot of pressure on cash if inventory is involved for a very simple reason: growing businesses have no real choice but to grow their inventory. Furthermore, unless a business can obtain new inventory very quickly or the net margin is very high, the cost to increase inventory is quite probably going to outpace the additional profits generated by the growth.

In other words, let’s consider a business doing $1 million in revenue has that has an inventory of $300,000 and nets a 10% profit ($100,000). If that business grows 100% in a year, the inventory probably has to grow from $300,000 to $600,000 while the profit increases from $100,000 to $200,000.

Starting cash $150,000
Cash in:
Profits $200,000
Cash out:
Inventory -$300,000
Ending cash $50,000
Net change -$100,000

This scenario is untenable but unfortunately, realistic. Getting cash flow and inventory under control is a thorny problem that cannot be ignored. So let’s talk about common sense ways to keep cash flow healthy while maintaining adequate inventory.

Tighten your supply times for less inventory

An easy and often inexpensive way to lower your investment in inventory is to lower the amount of inventory you need in the warehouse. The simplest way to do this is to lower the amount of time it takes to get inventory into your warehouse. Obviously, if it takes eight weeks to get more inventory, your inventory level has to be kept much higher than in a scenario where you can get inventory in eight days.

Finding ways to tighten your supply time might include finding new sources or paying for faster processing/shipping. As a general rule, these kinds of improvements may raise your product cost a bit (affecting profits) but lower the amount of money you have to have invested. You will have to evaluate the tradeoff between profit and investment based on your situation but it is often reasonable to accept less profit in order to lower your investment, especially if you (like us) tend to look at inventory cost from an ROI perspective.

Ask for (better) terms to improve cashflow

If you are a larger company, you are probably already used to asking for terms from your supplier. Terms essentially allow you to sell inventory you have not paid for yet which in some cases could reduce your investment to $0. For example, if you only need 60 days of inventory in the warehouse and can avoid paying for inventory for 30 days, you really only have to cover the investment of half of your inventory.

If you have terms, ask for better terms. If you do not have terms yet, ask for terms. And if you get told that you cannot get terms, never fear. You can survive without terms. We still buy the majority of our inventory without terms in order to maximize discounts. However, the impact of terms on cash flow is enormous and since it does not hurt to ask, make sure that you do.

Reevaluate your volume discounts

Placing a larger quantity of smaller orders reduces your inventory in the warehouse and increases cash flow. Thus, for some businesses, this kind of approach is very attractive. In addition to this, you may even be able to place just-in-time inventory orders for products you have already sold.

Virtually 100% of the time, you have to make a choice whether maximum profitability or cash flow is more important and figure out the right balance. You can always find a way to squeeze a bit more profitability out of your business by placing bigger orders, but sometimes that is the wrong decision. Remember that return on capital is important. It might be better to earn $100,000 on a $200,000 investment in inventory rather than $150,000 on a $400,000 investment in inventory. That is a decision you have to make.

Managed growth

If you are willing to limit your growth, you can manage your cash much better. As demonstrated above, quick growth can be extremely damaging to cash flow. However, there are simple formulas to help you determine a growth rate that works for you. Although they are beyond the scope of this article, if you would like, set up a time to speak with us and we will walk you through them.

Debt or equity deals

Both debt and outside equity count on the positive side of the cash flow report. Either can be used to solve cash problems but we are in favor of neither unless as a last resort. Therefore, if you need quick money and want to avoid giving up equity, regional banks will often lend 50% of inventory cost.

For those of you who are relentless about making it work, you will find that cash flow and inventory are not mutually exclusive. If you want more tips about this topic and similar topics, please sign up for our weekly newsletter below.

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