Small Business Matters: Optimize working capital through inventory management

Charles Yacoobian is a C.P.A., and a Business Advisor with the Small Business Development Center.
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By Charles Yacoobian
Small Business Development Center

Optimization of inventory levels is a potential solution to help manage working capital.  Adequate working capital is critical for the success of a business. Working capital is liquid assets available for day-to-day operations, or the ability of the business to meet current liabilities.  An example would be a business with the following:

Cash in the Bank – $1,000 (A)
Inventory on Hand – $3,000 (B)
Accounts Payable to Vendors/Suppliers – $2,000 (C)
Working Capital: [ (A) + (B)] – (C) = $2,000

Accordingly, business owners must find ways to increase their cash flow. Many will concentrate on increasing profits by growing sales, improving gross profit and reducing expenses. That’s a good starting point, but increased profits do not necessarily translate into more cash in your bank account.

Here are a few tips that I used for over 20 years as a consumer products wholesale distributor:

Tip #1 – Stock the minimum amount of inventory
The goal is to stock the minimum amount of inventory without negatively affecting sales. In other words, you want the highest order fill-rate using the smallest inventory possible.

Excess Inventory Impact:

  • May tie up funds that could be better used in other areas of the business.
  • Insurance premium cost may increase.
  • Storage space and related cost may increase.
  • Interest expense could increase on loans to finance inventory.
  • Risk of loss through product price declines in the market.
  • Risk of inventory deterioration or obsolescence.

Tip #2 – Analyze the inventory level
The business owner should analyze the inventory level by calculating the Inventory Turnover Rate.  The Inventory Turnover Rate is the number of times during a year that a business is able to sell the inventory on hand and replace it.

Here’s an example:
The business was able to decrease the inventory level from $297,000 to $273,000
with a benefit in the number of times the inventory was sold from 2.8 to 3.8.  The impact was less cash spent on inventory purchases.

Average inventory dropped from $297,000 in 2016 to $273,000 in 2017, while the average inventory turnover rate increased from 2.8 to 3.8 in the same period.

What constitutes a satisfactory Inventory Turnover Rate? It depends on the type of business and the type of merchandise. For example, a company selling fresh food should have a higher Inventory Turnover Rate than one selling furniture or jewelry.

In many businesses, the 80/20 Rule applies….20% of the items in inventory, generate 80% of sales. Customers will be happy and consider you a reliable supplier if the “order fill rate” on these items is 98%-100%. Anything less and they will seek another supplier. On the other items that comprise 80% of your inventory, the customer will be a little more forgiving if the item is out of stock

Tip #3 – Consider fine tuning inventory levels
After making the decision to consider inventory management as an opportunity, consider the following:

  • Once you submit an order to a vendor/supplier, how long does it normally take to receive the order?
  • Does the vendor/supplier have a high “order fill rate”?
  • Does the vendor/supplier offer “free freight” for orders exceeding a certain amount?
  • Are the products perishable?
  • If you discontinued some of a vendor’s/supplier’s products, what will the effect be upon sales?
    • If you don’t carry an item, will customers do business with your competitors?
    • If a customer wants $20 worth of an item you no longer stock, would you lose an order from the customer for $500 which includes other items you sell?
      (It may be worth stocking a limited amount of the slow moving item.)

A new way to view inventory as an opportunity to optimize working capital requires a closer look at your business, and why not minimize the amount of working capital sitting on the shelves or racks?

Charles Yacoobian is a C.P.A., and a Business Advisor with the Small Business Development Center (SBDC) hosted by College of the Canyons (COC), serving Northern Los Angeles County – the Antelope Valley, San Fernando Valley, and Santa Clarita Valley.  The column reflects the author’s views and not necessarily those of the Signal. For more information about how the SBDC can help your business, please call 661-362-5900, or visit www.cocsbdc.org.

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