According to JPMorgan Chase Institute, half of small businesses only have enough working capital to fund 27 days of operations. To avoid a capital crisis, cash flow management is therefore crucial.
For companies that sell physical products, cash flow is even more important.
Inventory-centric businesses invariably have capital tied up in non-liquid assets. In other words, items sitting on the shelf. If your business falls into this category, it's key to gauge how well you are converting inventory investment into cash.
By tracking the following three metrics, you can uncover inventory inefficiencies and take corrective measures to improve cash flow.
1) Inventory carrying cost
Inventory carrying cost is the total of expenses required to store items before they are sold and converted into liquid capital. Standing inventory not converted into cash incurs greater costs as time goes on and directly impacts profitability and cash flow.
Carrying cost is generally expressed as a percentage of the total value of inventory.
To calculate carrying cost, divide your inventory holding sum by the total value of inventory. Multiply by 100 to get a percentage of total inventory.
To do this, you first need to identify the four components of the inventory holding sum:
1) Capital costs
Capital costs are funds needed to purchase raw materials, pay interest on debt for materials purchases, and any other financing costs.
2) Service costs
Inventory service costs are indirect inventory management expenses such as the cost of IT hardware, software fees, insurance premiums, and taxes.
3) Risk costs
The two primary inventory risk costs come from shrinkage and obsolescence. Shrinkage is the loss of products due to damage, theft, or administrative errors. Obsolescence is when a product loses value over time or expires before it can be sold.
4) Storage costs
Storage costs are the funds needed to stock, organize, and handle inventory. This can include the cost of warehouse space, climate control, physical security, and the cost of handling materials.
How to calculate inventory carrying cost
To calculate your inventory carrying cost, you also need to know the total value of inventory. The total inventory value is the cost required to manufacture or purchase each item, multiplied by the number of available items.
At the end of each accounting period, you can find your inventory value under the current assets section of your company’s balance sheet. If you are in between accounting periods, use this simple formula to calculate total inventory value.
Now you are ready to put it all together in the inventory carrying cost formula:
Your business can use the carrying cost to inform optimal inventory levels and determine how much income can be generated from current stock levels. Carrying costs typically account for 20-30% of a business's total inventory value. If your carrying costs are above 30%, you should investigate the root cause. Common culprits include:
- Inventory surplus
- Inadequate sales
- Shrinkage and obsolescence
- Unfavorable financing terms
- Expensive 3PL arrangements
2) Inventory turnover ratio
Inventory turnover ratio, or inventory churn, measures the number of times stock on hand is sold and replenished over a given period of time.
To calculate inventory turnover ratio, choose a time period to analyze. A quarterly increment or an increment that reflects your sales cycle is a good place to start.
To arrive at your inventory turnover ratio, divide the cost of goods sold (COGS) by the average inventory. First, you need to calculate your COGS and average inventory.
Cost of goods sold
Remember, the cost of goods sold (COGS) are the direct expenses of producing goods which include the cost of purchasing inventory, the cost of labor, and associated purchases of supplies and services.
For a more detailed explanation of calculating the COGS, refer to our previous article on 3 Payment Metrics That Impact Cash Flow.
Average inventory is a measure of the mean amount of stock available over a specified period of time. For a simple way to calculate average inventory, add the starting inventory to the ending inventory, and divide the sum by two.
With your COGS and average inventory figures prepared, you are ready to calculate your inventory turnover ratio.
A high inventory turnover ratio is desirable because it indicates inventory is moving out quickly. A low ratio suggests stagnant inventory. And stagnant inventory increases carrying costs and reduces your business’s access to liquid capital.
You can calculate inventory turnover ratio for your entire warehouse or individual product lines. With a macro turnover measurement, you can better forecast overall cash needs. With a product line turnover measurement, you can identify underperforming sales lines and adjust procurements, pricing, and promotions to free up cash flow.
3) Days inventory outstanding
Days inventory outstanding (DIO), also known as days sales of inventory (DSI), is the inverse of the inventory turnover ratio. It measures the average number of days a company holds items before they are sold and converted into revenue. Whereas a high inventory turnover ratio is ideal (inventory moving out more frequently), a low DIO is best (lower number of days on the shelf).
To calculate your DIO, choose a time period (in number of days) to analyze, and plug your COGS and average inventory values into the following formula:
DIO rates vary by industry and product. Pharmaceutical companies, for example, have an average DIO of more than 90 days. Food products have an average DIO of less than 40 days. Check DIO industry benchmarks to see how your operations measure up.
Similar to inventory turnover, your DIO should inform appropriate stock levels and serve as a leading indicator for cash flow. If certain items have a higher DIO, stock less of this item and favor low DIO items instead to keep cash flowing in.
Combining data and digitization with Inxeption
At Inxeption, we help our customers use data insights to build better processes. Our suite of ecommerce tools helps business owners sell more efficiently online.
With Inxeption’s integrated dashboard, business leaders benefit from a consolidated view of inventory metrics, order records, and shipping data.
Inxeption’s product ledger connects to your online storefront so business owners can act on data insights by adjusting prices and promotions to keep inventory flowing out and cash flowing in.
By combining ecommerce tools with a greater understanding of your inventory performance, you can eliminate inefficiencies and move the needle on cash flow.
To learn more about Inxeption’s ecommerce technology, visit us online and request a free product demo.