Working capital is an important measure of a company’s financial health. It’s defined as the difference between Current Assets and Current Liabilities (Working Capital = Current Assets – Current Liabilities). When a company has positive working capital, it is able to pay off its short-term liabilities from assets that can be quickly converted to cash.
Inventory is a part of current assets and therefore has a direct impact on working capital levels. Because of its impact on working capital and for many other reasons, ensuring that inventory is managed properly is critical for business success.
Inventory:
Costs Related
Carrying inventory has many costs associated with it. These can be organized into the following categories:
Ordering Costs
These are the costs associated with inventory orders placed by your company. They include paperwork processing costs, handling, freight and in some cases setup costs for machinery.
Carrying Costs
These are the costs associated with holding inventory and include warehousing, insurance and the financing costs associated with funds used to purchase the inventory. If your company draws down $500,000 on a line of credit to purchase the most recent order, the interest costs on that “draw down” are part of inventory carrying costs.
Stock-out Costs
These are the costs – both real costs and opportunity costs – of not having sufficient inventory on hand. These include lost sales, costs associated with placing backorders and substitution costs.
Focus on the Goal
In a perfect world, you would know exactly how many units of inventory your business would sell on a given day and each unit would arrive instantly before the customer came to buy it. This scenario would all you to sell as much inventory as possible while minimizing the carrying costs. Maximum sales and minimum costs yield high profits. Since we don’t live in a perfect world, we have to do the best we can, balancing the need for having sufficient stock to avoid stock-out costs while at the same time minimizing carrying costs.
How Do You Know if You are Doing a Good Job?
There are three ratios that provide insight into your company’s management. Let’s assume a sample company over the last 12 months has:
- Cost of Goods Sold of $5 million
- Beginning inventory of $1 million
- Ending inventory of $500,000
- Average collection period of 45 days
Go to the article: How Well Are You Managing Your Inventory?
