Inventory – The Big Cash Drain – Asset or Liability?

When working with new clients and/or prospects that sell or carry inventory, I always ask the owner(s) how quickly their inventory turns. Without hesitation, most reply 6 to 8 times per year. Then I ask them how they calculated or arrived at that number. The universal answer is “I just know”. Maybe correct or more likely, probably not. I believe most of them are simply calculating their annual sales and simply dividing by their average inventory. For example, if they sell $6 million a year and their inventory balance is $1 million, they will say their inventory turns 6 times a year. Okay, that would be correct if inventory was carried at sales price, but inventory is carried at cost on the balance sheet, which assuming a 50% gross profit margin in this example, inventory would only be turning 3 times per year. (Please see actual formula for calculating Days Sales in Inventory below). Therefore, instead of having 60 days worth of sales in inventory on hand (360 days/6), they actually have 120 days worth of inventory on hand. No wonder most small to medium size companies are strapped for cash. I believe most of them don’t realize the tremendous cash flow repercussions of having too much inventory on hand.

Granted, most of us have been taught from day one in our accounting and finance classes that inventory is an asset. After all, it is classified on the balance sheet as a current asset, unless of course it doesn’t turn within a traditional annual business cycle, which then would require it to be classified as long term. In accounting humor, we refer to long-term inventory as FISH (First-In, Still-Here).

Let me challenge the status quo and current way of thinking and suggest that we start viewing inventory like a liability. Why? Well, were all too familiar now with terms like “Toxic Assets”, “Troubled Assets”, “Impaired Assets” and inventory often falls into this category. Why, because inventory can become obsolete, it can lose its value and it is highly susceptible to shrinkage (i.e. theft). Doesn’t it seem odd to hear terms like Toxic Assets, boy that’s an oxymoron if I ever heard one, right on par with “Jumbo Shrimp”. Inventory can become a Toxic Asset or Troubled Asset very quickly. There is nothing worse for your working capital position than having a large asset go bad. Inventory can be downright toxic if it isn’t planned and managed properly. Ever wonder why banks hesitate to lend against inventory. They simply don’t think they can recover enough cash value in the case of liquidation.

Days Sales in Inventory Formula = {Average Inventory/Cost of Goods Sold} x 360

I think the underlying moral of this story is, don’t fall in love with your inventory and think that you have a great asset on your books. Remember this sage piece of advice when managing cash and working capital “it isn’t what you sell, rather it’s what you buy, particularly how much and how often”.

As a B2B CFO®, I am experienced and skilled in helping companies analyze their optimum inventory and working capital components in order to maximize cash flow. If you are concerned with your current ratio, quick ratio, inventory turns and/or lack of cash flow, take a look at your inventory levels. Better yet, contact me and I can assist you in your analysis.

At B2B CFO® we genuinely care about our client’s success and we want each and every one of our clients to realize their dreams.

Cash. We Help You Get It.®

photo credit: Money Down The Drain 2 via photopin (license)