Any business that holds and manages inventory does so with the goal of selling that inventory to produce revenue for the company. The key is to maintain just enough to meet demand, but not so much as to have money tied up in inventory for a period longer than necessary. No business holding inventory desires to have more, or less, inventory than is needed to meet customer demand at any given time because failure to meet customer demand will negatively influence sales and profitability. These factors make inventory management one of the most significant challenges any business, but particularly a small business, can encounter.
Depending on the kind of business, there can be many different types of inventory. For example, manufacturers will likely have an inventory of raw materials, work-in-progress inventory, and finished goods inventory at a minimum. A retailer might have merchandise inventory, a service business might have an inventory of hours available to resell, and a magazine or online publication might have an inventory of space that could be filled with advertisements. How each business type manages its inventory may be a little different, but each has the same purpose in mind: To maximize cash flow.
Demand forecasts are an integral part of inventory management. If the business demand forecasts are incorrect, it can be a significant blow to cash flow. For example, if the business assumes the demand will be high, and the assumption is erroneous, it may have too much cash tied up in inventory assets, which in turn would restrict cash flow because the product on hand is not selling as predicted. Conversely, if the business predicts the demand will be low, and the assumption is incorrect, it may not have enough inventory to meet customer expectations, resulting in lost sales and therefore tighter cash flow.
One of the simplest ways to manage physical inventory is to measure productivity and turnover (Traster, 2007). The idea here is to determine how often during the year the business can convert its inventory assets into cash (learn more about inventory turnover and other financial ratios here). Assessing the most appropriate turnover rates is a factor of a company’s sales volume. The goal is to either turn the inventory more times over the course of the year or reduce the amount of inventory held at any given time to maximize cash availability. If money gets tight, it is smart to evaluate the slower moving inventory and determine how price adjustments might help improve sales and increase cash flow, even if the margin on the sale is lower than desired.
Another way to manage inventory levels to maximize cash is to improve supply chain processes using a just-in-time model. For example, gaining agreement from a supplier of raw goods to hold those items necessary to produce a finished product in the warehouse, but not take them into inventory until manufacturing demand requires it, means raw materials are not in stock before necessary. This is one way to hold on to cash a little longer. Another approach might be to make a process change and to delay final assembly and packaging of the product until just before a customer may need the product, thereby reducing labor costs and inventory levels until the very minute (Anderson, 2010). These are only a couple of ways that small modifications in the supply chain process might reduce inventory levels and improve cash flow.
Service businesses and publishers have a slightly different problem. In these companies, fixed inventory is available, and when it is not used in the defined period, it is revenue lost. A consulting firm or advertising agency might have calculated its available inventory of hours by assuming that every revenue-producing person should bill (to clients) an average of 95% of his or her hours per each week for the firm to be successful. Assuming a 40-hour work week and 30-minutes for lunch each day, each should bill 35.625 hours per week. If less than 35.625 hours are billed, that inventory of hours and the revenue it would have produced is lost. The firm must somehow make up that lost revenue elsewhere. Sometimes, hourly rates are increased over time to help make up the difference. But often the solution means firing those who consistently under-perform.
Publishers allocate and maintain an inventory of advertising space within a publication for a specific time. If the advertising does not sell before the publishing deadlines, the revenue is lost. To offset lost revenue, the publisher might offer deep discounts on the unsold space at the last minute to improve cash flow. The publisher might also increase the inventory availability in subsequent issues in an attempt to recoup revenue lost to unsold advertising space.
Inventory management is an art and science. It requires diligence, a reliable inventory system, and designated staff to maximize cash efficiencies. While different business types have different requirements for inventory levels, all businesses must have a keen understanding of their customer needs and market demands to forecast need. Moreover, companies must have a detailed knowledge and control of cost and production schedule to ramp up, or down, depending on the demand forecast. Striking the proper balance with inventory is vital to maximizing cash flow.
Anderson, L. (2010). Accelerating Cash Flow Through Supply-Chain Innovation. MWorld, 9(1), pp. 36-38.
Traster, T. (2007, May 14). 5 steps to get a grip on inventory. Crain’s New York Business, 23(20).
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In an earlier post, Financial Ratio Analysis and the Entrepreneur, I shared some insights on Financial Ratio Analysis and how investors and lenders may consider and use financial ratios to determine whether to invest or lend to an entrepreneur. Entrepreneurs should also understand how to use financial ratios in the regular course of business operations. Each financial ratio has a purpose, and when compared to industry benchmarks, a ratio can provide insights as to a venture’s performance as well as help set stretch goals for business improvements and growth.
The most common financial ratios used by investors and lenders include:
These ratios indicate the long-term solvency and highlight the extent long-term debt is used to support the venture. Leverage Ratios include:
- Debt-to-Equity Ratio which measures how much debt is used to run the business.
- Debt-to-Asset Ratio which measures the percentage of the company’s assets that are financed by creditors.
Learn more about Leverage Ratios and how to calculate them here.
These ratios measure the businesses ability to cover its debt and provide a high-level overview of financial health. Liquidity Ratios include:
- Current Ratio which estimates the company’s ability to generate cash to meet its short-term commitments.
- Quick Ratio which measures the ability to access cash quickly for immediate demands.
Learn more about Liquidity Ratios and how to calculate them here.
These ratios offer insights into operations and help to spot problem areas related to inventory management, cash flow, and collections. Efficiency Ratios include:
- Inventory Turn-over which examines how long it takes inventory to be sold and replaced within a year.
- Average Collection Period which looks at the average number of days it takes customers to pay for goods or services.
Learn more about Efficiency Ratios and how to calculate them here.
These ratios evaluate the financial viability of a venture and provide a measure of comparison and performance to the venture’s industry. Profitability Ratios include:
- Net Profit Margin which measures how much a company earns after taxes relative to sales.
- Operating Profit Margin which measures earnings before interest and taxes (EBIT).
- Return on Assets which provides insights on how well management is using the company’s resources.
- Return on Equity which measures how much the company is earning for each invested dollar.
Learn more about Profitability Ratios and how to calculate them here.
As I mentioned in the previous post, these are just a few of the ratios used in determining the health and viability of a given business. Together with other factors such as customer acquisition costs, these ratios provide a great set of tools for managing an entrepreneurial venture. Fully understanding these ratios and the implications on the venture will be beneficial for an entrepreneur before he or she seeks additional investment or debt financing.
Here are a few resources that might be beneficial for identifying industry comparisons for your industry:
- RMA Annual Statement Studies. Data on business for comparisons
- Almanac of Business and Financial Ratios ($)
- Financial Studies of Small Business ($ or library)
- Bank Rate Small Business Ratio Calculators
Rogers, S. (2014). Entrepreneurial Finance: Finance and Business Strategies for the Serious Entrepreneur. New York: McGraw Hill Education.
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Lenders, and often investors, will calculate one or more financial ratios when reviewing an entrepreneur’s financial statements to gain a quick understanding of the health of the business before determining whether to lend or invest. Within an industry, there will be “good” and “bad” benchmarks against which the venture will be measured (Rogers, 2014). Investors and lenders will consider the particulars of a business and likely weight the importance of the ratios differently when comparing to the industry benchmarks.
Many financial ratios could be applied, but the following appears to be most common types (BDC Staff, n.d.):
Leverage Ratios. Leverage Ratios provide an indication of the long-term solvency and highlight the extent long-term debt is used to support the venture.
Liquidity Ratios. Liquidity Ratios measure the businesses ability to cover its debt and provide a high-level overview of financial health.
Efficiency Ratios. Efficiency Ratios provide insights into operations and help to spot problem areas related to inventory management, cash flow, and collections.
Profitability Ratios. Profitability Ratios evaluate the financial viability of a venture and provide a measure of comparison and performance to the venture’s industry.
There are other ratios, of course, and as mentioned before investors particularly have ratios they rely on more based on their experience and industry knowledge. For example, a recent interview with an investor uncovered a preference for knowing the Customer Acquisition Costs. Customer Acquisition Costs are not often viewed as part of a Financial Ratio Analysis, but such factors are often important measures for both investors and entrepreneurs alike.
The entrepreneur, investor, and lender can gain useful information and financial trends on a business venture when using Financial Ratio Analysis. However, it is important to note that financial ratios have little meaning without comparison (Peavler, 2017). For example, a company can compare its ratios to those average ratios of their industries, but the best and most accurate comparisons come from using benchmark companies—high performing companies within their industry. Comparisons against these companies can create and encourage stretch goals for a business.
While Financial Ratio Analysis does provide numbers for performance comparison, it does not provide causation factors (Peavler, 2017). Moreover, identifying why certain ratios that are out of line with the benchmark comparisons is critical because it provides a starting point for correcting problems and improving financial performance. Ratio analysis can have value for entrepreneurs but depending on where the venture when it is seeking funds, these ratios may or may not be helpful in securing financing.
Entrepreneurs seeking early-stage financing are more likely to encounter investors who value continual improvements in customer acquisition costs, improvements in customer engagement at the various points of contact, and repeat purchase or purchase frequency. These measures help the investor gauge the interest in the offered products and services and are often a good predictor of long-term revenue.
Conversely, established entrepreneurial ventures—those that have several years financial history—looking for ongoing financing are likely to find as much emphasis placed on financial ratios as is placed on the customer measures noted above. This particularly true with bank financing because bankers are more risk adverse and financial ratios when properly utilized, provide a more objective measure of a venture’s performance compared to its industry thereby giving bankers a greater level of comfort when lending money.
Entrepreneurs are often motivated to launch a business in part because of their interest and expertise in a specific domain area. However, many entrepreneurs may be less skilled when it comes to the business finances beyond the basics of revenue and expenses. As an entrepreneur’s business grows, understanding key aspects of finance becomes increasingly more important, particularly should he or she seek outside investment or financing. It is important to understand the basics of Financial Ratio Analysis and how it can be used to determine the health of a business before seeking investment or financing. Yet it is equally important to understand that Financial Ratio Analysis is only one tool in an investor or lender’s tool-box. And while it is an important tool, it is not the only tool that might be used, particularly by investors, when determining the probability of long-term success of an entrepreneurial venture.
BDC Staff. (n.d.). 4 Ways to Assess Your Business Performance Using Financial Ratios. (Business Development Bank Canada) Retrieved September 29, 2017, from bdc.ca: https://www.bdc.ca/en/articles-tools/money-finance/manage-finances/pages/financial-ratios-4-ways-assess-business.aspx
Peavler, R. (2017, February 28). Limitations of Ratio Analysis. Retrieved September 30, 2017, from thebalance.com: https://www.thebalance.com/limitations-of-financial-ratio-analysis-393236
Rogers, S. (2014). Entrepreneurial Finance: Finance and Business Strategies for the Serious Entrepreneur. New York: McGraw Hill Education.
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