Managing and accounting for your inventory

Managing and accounting for your inventory is one of the most critical functions for a business that maintains an inventory of goods to be sold. Through a variety of free tools, you can streamline your inventory-taking and -management times.

Inventory describes the extra amount of merchandise or supplies your business keeps on hand to meet the demands of your customers. If your business is in retail sector, your largest asset is probably your investment in inventory.

If your business involves manufacturing goods, your inventory will likely consist of materials needed for producing the final product, work in progress and finished goods. If you have a service-related business, you may hold an inventory of goods or materials needed to perform your services for your customers. Then again, you might have a dearth of inventory, especially if you're in a field like consulting.

What your inventory means to your financial health

Much like accounts receivable, inventory represents an investment of your business's cash—cash that cannot be used for other cash outflow purposes. Typically, a business purchases inventory and either pays for it at the time of the purchase, or within 30 days.

Depending upon the nature of your business, it may be days or weeks (or months or years) before the inventory is resold or used in the manufacturing of a final product then sold. Therefore, your business's investment in inventory has a significant impact on your cash flow. An over-investment in inventory reduces the amount of cash that could be available for other outflow purposes. Good cash flow management requires that you examine your inventory investment to avoid an over-investment.

These inventory analysis tools can be used to help manage your investment in inventory:

• Average inventory investment period
• Using the average inventory investment period
• Inventory to sales ratio
• Turnover analysis
• Using turnover analysis
• Exploring our turnover analysis case study
• Trying the Interactive Inventory Calculator Tool

Analyzing your average inventory investment period

The average inventory investment period measures the amount of time it takes to convert a dollar of cash outflow, used to purchase inventory, to a dollar of sales or accounts receivable from the sale of the inventory.

An easy way to process this concept is thinking of the average investment period for inventory much like the average collection period for accounts receivable. A longer average inventory investment period requires a higher investment in inventory. A higher investment in inventory means less cash is available for other cash outflows, such as paying bills.

The average inventory investment period is calculated by dividing your present inventory balance by your average daily cost of goods sold:

The average daily cost of goods sold is computed by dividing your annual cost of goods sold amount by 360:

The average inventory investment period can be a useful tool to help you manage your cash flow. Using the annual cost of goods sold amount and inventory balance from a prior year's balance sheet is usually accurate enough for analyzing and managing your cash flow.

If more recent information is available, such as the previous quarter's cost of goods sold information, then use it instead. Be sure to compute the average daily cost of goods sold correctly using the number of days actually reflected in the cost of goods sold figure. For example, 90 should be used if a quarterly cost of goods sold amount is used.

Example

Michael Angelo operates an art supply shop. All sales are cash sales. According to Michael's tax return filed last year, his cost of goods sold amount for the year was $195,000. Last year's ending inventory balance was $51,500. Michael's average investment period in inventory is calculated as follows:

Michael's average cost of goods sold is $542 per day:

The average investment period in inventory is 95 days:

For Michael's previous year, it took 95 days to convert a dollar invested in inventory to a dollar of sales. If Michael's business has not changed drastically from the previous year, the cash outflow from the purchase of the inventory will not create a cash inflow from the sale of the inventory for 95 days, on average.

Using average inventory investment period to manage cash flow

The average inventory investment period can be used to determine the effect of different inventory investment periods on your business's cash flow. Using the average inventory investment period will help you understand how a change in the average period affects your cash flow. This is best illustrated by the following chart.

The above chart illustrates the effect a change in the average investment in inventory has on the investment in inventory for your business. Remember, inventory is money that cannot be used for other cash outflow purposes until the inventory is actually sold.

For example, assume that your cost of goods sold per day is $300, and that your average inventory investment period is 100 days. Now assume that you were able to reduce your average investment period from 100 days to 70 days. From the illustration above, you can see that the reduction in the average inventory investment period reduces the investment in inventory from $30,000 to $21,000. This reduction generated an additional $9,000 in your cash flow.

Understanding the inventory to sales ratio

This ratio looks at your investment in inventory in relation to your monthly sales amount. The inventory to sales ratio helps you identify recent increases in inventory. In contrast, the average inventory investment period may only report inventory information from the previous year, if that was the only information available to calculate the period.

The inventory to sales ratio can serve as a quick and easy way to look at recent changes in inventory levels, since it uses monthly sales and inventory information. This ratio will help predict early cash flow problems related to your business's inventory.

The inventory to sales ratio is calculated by dividing your inventory balance at the end of any month by your total sales for the same month.

Example

Jeff's inventory balance for the previous month was $24,000, and the total sales amount for that same month was $9,600. Jeff's inventory to sales ratio is 2.5 and was calculated as:

$24,000
$9,600

Using the inventory to sales ratio

At first glance, the inventory to sales ratio might seem too simple to yield any useful information. But when reviewed on a month-to-month basis, the inventory to sales ratio can signal potential problems in your cash flow. For example, an increase in your inventory to sales ratio from one month to the next indicates that one of the following is happening:

• Your investment in inventory is growing more rapidly than sales
• Sales are dropping

No matter which situation is causing the problem, an increase in the inventory to sales ratio may signal an oncoming cash flow problem. Likewise, a decrease in the inventory to sales ratio from one month to next indicates that one of these is occurring:

• Your investment in inventory is shrinking in relation to sales
• Sales are increasing

Here again, no matter which situation is causing the reduction in the inventory to sales ratio, either one suggests that you are effectively managing your business's inventory levels and its cash flow.

Inventory investment and turnover analysis

Turnover analysis is the most basic and fundamental tool for controlling your investment in inventory. The process looks at your business's investment in individual items or groups of items making up your entire inventory. Turnover analysis then helps you decide if your investment in an inventory item, or groups of items, is excessive, too low, or just right. 

From a cash flow perspective, performing turnover analysis is particularly useful for finding inventory items that are over-stocked. Remember, an excessive investment in inventory results in less cash available for other cash outflow purposes, such as paying bills.

Since turnover analysis focuses on individual inventory items or groups of items, it requires that you make a periodic count of all the items making up your total inventory. Your business probably already takes a physical count of its inventory items, so the information necessary to perform turnover analysis may already be available. If you are just beginning your business, be prepared to make a periodic count at least once a year, if not more often.

Turnover analysis also requires that you know the number of inventory items sold on an individual basis. This may seem like an awful lot of work just to determine if the investment in a particular inventory item or group of items is excessive. However, the information provided by the analysis will make it all worthwhile.

Analyzing turnover vs. average inventory

There are some limitations to the information provided by the average inventory investment period calculation. First, as the name implies, the average inventory investment period is an "average." Because it is an average, it assumes that all products are the same, each selling at the same rate, and each costing the same amount. Secondly, the calculation assumes that your inventory only contains one product. Most likely, your business carries a number of different products; some selling faster than others, and others costing you more to purchase.

Turnover analysis goes beyond the average assumptions made by the average inventory investment period. It does this by requiring you to look at each product or line individually, taking into account the number currently on hand, the number sold and the number on hand in relation to the rate at which each item sells. So, turnover analysis can be used to pinpoint the specific inventory items that are creating an excess investment in inventory, thus creating cash flow problems.

Using turnover analysis

Turnover analysis helps you decide if your investment in a particular inventory item or in a group of items is excessive, too low or just right. From a cash flow perspective, performing turnover analysis is particularly useful for finding inventory items that are over-stocked. 

Remember, an excess investment in inventory results in less cash available for other cash outflow purposes, such as paying bills or meeting payroll. Pinpointing inventory items held at excessive levels, and reducing those levels helps reduce your total investment in inventory. Reducing your total investment in inventory helps improve your cash flow.

Performing turnover analysis requires you to look at each individual inventory item for the following information:

• The number of items currently held in inventory
• The number of items sold during the measurement period (expressed in days, Generally 30 to 60 days)
• The number of items held in relation to the measurement period

Once the information is compiled for each inventory item, you can then determine if the level for each item is excessive, too low or just right. In some cases, you may want to save time by using departments or product lines rather than individual items for your initial turnover analysis. If you find a department or product line that's causing trouble, you might go farther and do a turnover analysis of each item in that grouping.

Case study: Turnover analysis

Turnover analysis allows you to determine if the inventory level for each individual inventory item is excessive, too low or just right. This example shows an inventory analysis turnover schedule, and how the information can be used.

Jeff Hammer, owner of Handy Hardware, has been experiencing some cash flow problems, causing him to draw on the store's line of credit at the bank more than he was expecting. Jeff has noticed a significant buildup in the inventory of the home repair and improvement section of the store. Sales in this department have remained steady, but the average inventory investment period and the inventory to sales ratio have both increased over the last three months. Jeff's goal is to stock the number of inventory items necessary for about 30 days of sales.

Jeff has decided to perform a turnover analysis on the home repair and improvement inventory items. He has just completed his mid-year physical inventory count so the number of items held in inventory is already available. The number of a particular item sold was compiled using information gathered at the time a customer checks out. The following is an excerpt from his turnover analysis schedule:

Based on the information from Jeff's turnover analysis, he has determined that his inventory level in three out the five items listed above is too high. Reviewing the results a little closer shows that Handy Hardware had 392 gallons of paint on hand as of 6/30/2010.

Only 121 gallons were sold in the last 30 days. The inventory of paint on hand is enough for three months' sales. Jeff could reduce the inventory of paint by two-thirds, and still have enough paint inventory to cover one month's sales amount.

The turnover analysis of paint brushes and rollers showed much better results. Sixty-six paint brushes and rollers were on hand as of 6/30/2010. Fifty-four brushes and rollers were sold during the last 30 days. Using this information, Jeff determined that there was enough inventory of these items to supply 37 days of sales. This is very close to the 30-day level Jeff feels is optimal for his hardware store. No reduction is necessary for these inventory items.

The results for the paint remover showed that the hardware's level of inventory was too low. Only a 20-day supply of paint remover was held in stock at the end of June. Jeff will need to increase the amount of paint remover stock to ensure that at least 30 days' worth of paint thinner sales remains in stock.

The schedule also showed that excessive levels of paint thinner and sand paper sheets were held on 6/30/2010. In both cases, Handy Hardware was holding well over the 30 days' sales amount that Jeff determined to be the best level for the store. A reduction in the inventory of both items is called for.

The turnover analysis shown above helped Jeff determine the specific items creating a buildup in the inventory of the home repair and improvement department of his hardware store. Eliminating the excess inventory levels will reduce the size of Jeff's investment in inventory and improve his cash flow.