If your company makes or sells products, some amount of inventory is needed, and funding inventory requires cash. Purchasing and holding raw materials, building finished goods, or buying completed products from vendors that are held for resale, demand some portion of a company’s cash.
For a manufacturer or distributor, the cash required to fund inventory can be significant. If sales are seasonal or the production cycle is long, even more cash is needed. Unfortunately, owners and managers sometimes forget that INVENTORY = CASH.
Accounts receivable and inventory are current assets, so one expects both to be converted to cash within a year. The problem is that companies often focus on how quickly receivables get converted to cash but not how quickly inventory is turned to cash. When a small business’s cash flow gets tight, focusing on accounts receivable can provide an immediate solution. Collecting a few large, past due invoices can quickly generate additional cash. In fact, prompt collections are so important that business owners and managers generate accounts receivable aging reports, which are reviewed and shared with others to ensure collections remain current.
Unfortunately, many small businesses do not have access to similar reports showing the length of time inventory is held. One may have reports showing current inventory dollars and quantities by item, out of stock inventory, or vendor costs by item, but an inventory aging or an inventory turnover report may not exist. If companies do not measure the number of days that inventory is held, inventory turns can slow, which requires more cash.
A financial ratio called Days Inventory Outstanding (DIO) can be used to calculate how long inventory is being held. With this ratio, a company can determine how many days it currently holds inventory for comparison with past periods. If DIO increases, more cash is needed to fund inventory. If DIO decreases, less cash is needed. Below is the formula used to calculate Days Inventory Outstanding and some suggestions about how it can be used to better manage a business’s cash flow.
Days Inventory Outstanding = (Average Inventory / Cost of Goods) x Number of Days in the calculation period
1. Calculate DIO for current and past periods and compare—There is no single, correct DIO figure for all companies and industries. DIO is a ratio used to show trends, so it should be calculated for current and past periods and then compared.
2. Initially, calculate a single DIO ratio for all inventory—Calculate a company-wide DIO figure that includes all inventory. If inventory is being held too long, then research to determine the cause.
3. The calculation does not have to be perfect—Include only inventory-related cost in the cost of goods figure, if possible. If your inventory value includes only material and freight costs, then try to include only those in your cost of goods figure. If separating inventory-related costs from all other cost of goods is too difficult, then use total cost of goods. Calculating the ratio consistently over each period is more important than being perfect.
4. Later, calculate DIO for specific inventory categories or product lines—If you sell hotdogs and sodas, try to calculate a DIO ratio for hotdogs and a DIO for sodas. Hotdog inventory may turn very quickly while soda inventory turns slowly. You can then focus on improving the slow turning inventory.
5. Focus on selling old inventory and over-stocked inventory—Having $500 in cash now is better than having $700 in pumpkin-flavored soda sitting in inventory for three years. Identify old and over-stocked inventory and convert that inventory to cash. This reduces total inventory and improves DIO.
Cash that is used to fund and hold inventory is cash that a company does not have available elsewhere. Using a financial ratio such as Days Inventory Outstanding can help managers identify when inventory is being held longer than targeted or expected. With this knowledge, managers can then work to reduce days outstanding to squeeze extra cash out of inventory.
Content contributed by Potter & Company, a local certified public accounting firm offering core services of tax, audit, business consulting and financial analysis. Content written by Michael Waddell, Financial and Management Consultant. For more information, contact him or John Kapelar, CPA, Partner, at 704-283-8189 or visit www.GoToPotter.com.