Holding excess inventory is never a good idea – and when interest rates go up, it can be critically dangerous. In Australia’s current low-interest climate you can easily be lured into holding more stock than you need – and this may come back to haunt you when the inevitable increase in interest rates occurs.
No doubt you have heard the term ‘inventory turns’. This is the number of times during a year that your inventories are turned over. For example, if the cost of your sales is $1 million per year, and you hold $500,000 of inventory, your turn rate is two.
From a management perspective, the higher the rate of inventory turn, the lower the amount that you have invested in your inventories – and therefore the lower the risk to your business. So it’s very important that you have a clear goal for your inventory turn rate.
If you’re making sales on credit terms, it becomes critically important that you manage both inventory levels and debtor collections. This article only explores the former, but you’ll find guidance on debtor management here.
Establish smart buying patterns
One of the most important tools your business can have is a readily accessible record of sales patterns for all your products. Armed with this knowledge you’ll be able to safely minimise the level of stock that you hold.
After all, while it’s important not to hold too much inventory, it’s just as vital that you don’t run out. Determine how long it will take to replenish each of your products as they are sold. (If you’re relying on the direct import of products, that will obviously take much longer than if you can buy directly from a local supplier).
You can then use this information to establish your buying patterns. Of course, you need to have sufficient product sitting on your shelves to meet demand from customers as it occurs. But you don’t need to have enough inventory to supply the projected needs of customers for three months, if you can re-order and get supply in three weeks!
Use supplier credit to finance your stock
Ideally, you should try to match your inventory requirements to your suppliers’ terms of trade. For example, if your supplier grants you 30 days’ credit on purchases, and you are making your sales on a cash basis, you will have no working capital tied up in inventories if you can restrict your stock levels to less than 30 days’ projected sales. (In this example your inventory turn rate is 12).
Many suppliers allow you to pay for product at the end of the month following acquisition. If you can take advantage of such terms, then consider making your purchases in the early days of a month rather than towards the end, as this can give you up to twice as long to pay for the product.
Be careful about acquiring large volumes of product if a supplier is offering discounted prices. At first glance, getting a 5% discount for placing a substantially larger than normal order for product may be attractive. But do your sums before buying up big. Under normal terms of trade, you’ll need to find the funds to pay within 30 days of delivery. If the product is going to sit on your shelves for a long time you’ll end up committing more of your working capital to the financing of your inventory. If, like most businesses, you are working with borrowed funds, the 5% discount will quickly be eroded by interest charges.
Beware of obsolescence
Another very important thing to consider is the likelihood of product obsolescence – or holding product that passes its recommended ‘use by’ date. The longer that you hold a product, the more likely it is to become obsolete.
Even if you don’t become a victim of obsolescence, you could end up holding excessive supplies of product that, whilst still saleable, is very slow moving.
Of course this is not a perfect world, and the chances are that at some time you’ll be faced with one of these scenarios. If that happens it’s better to accept that you got it wrong and to sell the product at a discount as quickly as possible than to have it decline to the point where it has no value, or your profit margin is totally eroded by your holding costs.
You may even be able to use this as an opportunity to attract bargain-hunting customers to your business – and in the process sell them other products that are more profitable to you.
Following these 3 strategies to prudently manage your stock levels and buying habits can have a big impact on your cash flow – leaving you with more working capital on hand and greater resilience to income fluctuations.