When Inventory Is Not An Asset
Aug 29, 2009
I mentioned to an owner of a business a while ago that inventory is not an asset. She looked at me and probably wondered if I knew what I was talking about.
"I'm not an accountant," she said, "but I do know that inventory is an asset. It's even shown as a current asset on my balance sheet, I sell it to my customers to get the cash, and I couldn't run my business without it. How can you say that inventory is not an asset?"
She is right, of course. But what she and most other owners don't focus on is that inventory can just as easily be a liability to a company unless the company is very careful to ensure they get the most out of the inventory.
In fact, an owner should look on every piece of inventory as a liability until that inventory is sold and it becomes a receivable. Until that point, every dollar invested in inventory is a dollar the company cannot use elsewhere in the business.
Inventory is insidious in that it often, slowly, consumes a lot of the resources of a company. Of course, most companies do need a certain level of inventory in order to meet the demands of customers. But it warrants careful and ongoing attention.
- In most cases, inventory is purchased and paid for long before it is sold to a customer.
- For some period of time it sits in a warehouse, and the cost of carrying that inventory (i.e., interest expense) reduces the company's profits.
- Moving the inventory always raises the possibility of damage, but some inventory will diminish in value just sitting there.
- A rule of thumb: The more inventory you have, the more will "disappear." That costs the company more money.
- Maintaining large levels of inventory requires people to manage it, adding wages, benefits and other costs.
So a company should look carefully at every dollar it invests in this "asset." To do so, the company needs to understand what they have, and why they have it. The company must be sure it has the right information:
- Routinely prepare and review detailed reports about the inventory. How much do we have? What kind of inventory is it (finished goods, raw materials, work-in-process, or other categories)? How much of each type?
- How often does the finished good turnover? What are sales of the finished goods, and what level of sales are expected in the near future? Based on that forecast, is there too much inventory on hand?
- Categorize inventory, based on turnover and expected sales, into A, B and C items, with A being the "best" or fastest moving, and C being the slowest moving.
- Identify inventory, including the C items, which the company does not expect to sell in sufficient quantities over a short period of the future.
- Identify a plan to dispose of slow-moving or unneeded inventory.
With regards to the last point about slow-moving inventory . . . at some point, goods will be identified that need to be sold at lower prices than in the past. If there is no longer a market for those goods, or if the company has decided to discontinue selling those products, there is no reason to hold on any longer. The goods need to be sold or, if necessary, discarded. This is not a time to worry about the impact on the company's income statement. At this point, it is a balance sheet and cash issue, and every dollar received from selling that inventory is a dollar of cash in the company's bank account. And the other costs—the carrying costs noted above—can be reduced at the same time.
So, when is inventory NOT an asset? When the company is not selling it quickly. Otherwise it is an expensive liability. Spending time actively managing inventory will reap rewards—cash rewards. And remember—cash IS ALWAYS an asset.