In the first installment of this blog series, we learned about the tremendous impact the balance sheet can have on the health of a company. We talked about how the income statement and balance sheet play two very distinct, equally important roles, and how understanding both of them is critical to operating a well-managed company. To help us navigate what can be a pretty confusing topic, we were introduced to Mike Thomas, CEO of the fictitious Alpha Widgets Corporation.
If you’ll recall, Mike was just starting to dig into a pile of month-end financial statements to see if he can figure out why, despite posting huge sales numbers all year, the company’s bank account feels strained. He wants to know if he’s running Alpha efficiently and how he can optimize his balance sheet to help support growth without risking the health of the company. As Mike starts to dig into Alpha’s financials, one of the patterns beginning to emerge is that the Company has a lot of money tied up in its inventory.
How a business manages its inventory can have a tremendous impact on the financial health of the company. Managed properly, inventory can be a great source of increased margins, higher revenue, or a combination of the two. As a manufacturer, Alpha maintains a sizable inventory of both raw materials used to make its widgets and finished products that are then sold to its customers (many manufacturers also carry an inventory category called “Work in Process,” which is made up of partially-finished goods, but for simplicity’s sake we’ll pretend that Alpha doesn’t carry any WIP). How can Mike know if Alpha is effectively managing its inventory?
In general, there are a few rules to remember when talking about inventory.
1. Understand the all-in price of your inventory
This first rule is simple: always know what your inventory costs. Cost is not merely what you paid a supplier for it. You need to understand the all-in price, which includes things like storage, obsolescence, spoilage, borrowing (if you are carrying balances on lines of credit), supplier discounts and the opportunity cost of capital that could be used elsewhere. Remember, every dollar tied up in procuring and keeping inventory is a dollar that cannot be spent elsewhere, so knowing how many dollars are really invested into your inventory, especially as it ages, is an absolute must.
2. Optimize your inventory for an efficient return
Second, a business should carry enough inventory to support its sales objectives and growth, but not so much that it becomes an inefficient use of capital. The trick lies in calculating what the “efficient” (or desired) return on capital should be for your business, and then either optimizing inventory to help reach it or increasing your gross margins to compensate for the all-in cost of carrying more inventory.
For example, take a company that specializes in hard-to-find appliance parts, shipped within 24 hours. To be able to do that, this company would have to stock a very diverse, large inventory so it can fill the order and ship it right away. The cost of maintaining such an inventory would be tremendous, as it could be years before some of the more obscure parts are sold and converted to cash, if ever at all. To counter these costs, the company should charge a premium price for its products, which presumably its customers would happily pay due to the hard-to-find nature of the parts and the fast shipping.
In contrast, a gas station sells a high-volume, more commoditized product that could be easily bought from any number of other sellers. For this reason, gasoline sells at a much lower margin because its customers could go down the street for a better price. Most of the time, the owner does not have the option of increasing prices to compensate for excess inventory because doing so would negatively impact sales. Instead, the opportunity to achieve higher returns on capital comes from things like reducing the all-in cost of every gallon of gasoline and carrying a wide variety of high-margin convenience items (as a side note, this concept is why gas stations are so often connected to a convenience store). If a gas station owner can use effective balance sheet management to lower his all-in cost of every gallon of gasoline even by a few cents that can translate to a meaningful increase in net income when selling thousands of gallons a week.
3. Weigh the pros and cons of holding costly inventory
Lastly, the shorter the expected usable life of your inventory, the less room for error you have. If you’re selling bananas, it’s a matter of days before they become unusable by anyone not making banana bread, so you have to know how many to keep on hand at any given time. Raw steel, on the other side, will remain usable for years assuming it’s not left outside in the rain, although by then storage costs will likely have eaten away any profits it would have made.
While this concept is obvious to most business owners, what isn’t as obvious is knowing when discounting the price of your products is less expensive than continuing to hold costly inventory. While it may be painful to sell your product at a discount, if it frees up capital to be better utilized then it may be a good idea. This is another reason why understanding your all-in cost of inventory matters; it can help you calculate how much profit you’re losing every day you hold out for a higher price.
Whether talking about inventory, accounts receivable, equipment, real estate or any other non-cash asset, they all represent the use of cash because cash was used to acquire them. Since you can’t walk into a grocery store and pay for a gallon of milk by handing the cashier a gallon of gasoline from your inventory, your goal as a business owner has to be figuring out how to transform your assets into a source of cash.
Beginning to think of your balance sheet in terms of sources and uses of cash might transform how you approach your business.
Here are a few quick examples of what thinking in terms of sources and uses looks like:
- Turning inventory (use) into revenue (source).
- Turning outstanding accounts receivable (use) into received payments (source).
- Buying a building (use) with a loan from Elevations Credit Union (source), thereby increasing net income (source) by paying less in interest (use) than you were paying in rent (use).
- Using your Elevations business line of credit (source) to give you the cash you need to pay your inventory suppliers faster (use) and take advantage of payment discounts that you otherwise couldn’t. As long as the money saved with the payment discount is more than the interest paid (use) on the borrowed funds (source), the increased net income becomes, you guessed it, a source.
In our next installment, we’ll discuss what effective accounts receivable management looks like, and you may be quite surprised to learn the difference even a few days can make. Be sure to subscribe to our Business Banking email list so you don’t miss the next blog in this series!