Small business tip of the week: How much is too much inventory?

Feb. 9, 2011 at 5:03 p.m.
Updated Feb. 8, 2011 at 8:09 p.m.

In his most recent article, my colleague, Stephen Kilgore, wrote about mismanaged or out-of-control accounts receivable, and the ultimate effect on your cash flow.

My article today focuses on the effect of mismanaged or out-of-control inventory in a business.

In business, cash is still king. Finding the cash your business has generated in profits is a different matter. Most business owners agree the preferred place for their money is in a bank account, eliminating the need for short-term borrowing.

Often times, a business' inventory gets out of control because of limited management controls or just a simple creep of a problem over time.

The inventory I refer to are the goods and products businesses have on hand to sell for a profit to their customers.

Retail businesses have their inventory on shelves and in storage areas. A manufacturing firm will have several different types of inventory - from the raw material, to the work in progress and the finished product. A service company has materials used in the completion of jobs, such as pipes and fittings for a plumbing contractor.

The cost incurred for this inventory is preferably paid with cash, not borrowed funds. It is important to know the effect your inventory value has on your business' cash flow.

Knowing the inventory's historical monthly trends will enable the business owner to plan cash flow needs.

What is the proper level of inventory for any given business? The simple answer is: It depends. Each industry and individual business will have certain trends. A business owner can look to published industry data to determine what an average inventory turn is for their particular industry.

Inventory turn is the number of times an inventory is sold during 12 months. For example, the average turn for convenience stores is a little more than once a month. In other words, if a convenience store does $120,000 in annual sales, the average inventory on hand should be $10,000, or the inventory equaling the sales for 30 days.

Having too much inventory on hand ties up the cash of a business. Not enough inventory causes a loss in sales. Managing this inventory is similar to all other management strategies in a business: It needs to be timely and consistent.

As a business owner, you should be interested in not only what your inventory turn is, but also how your inventory numbers compare to the industry average.

You do not necessarily need the same turn as the industry, but you need to know the drivers of your individual business. Remember, inventory does affect cash and cash flow; you need to know how your business' inventory is affecting your business.

At the University of Houston-Victoria Small Business Development Center, all of our advisers are capable of analyzing with you the financial position of your business.

Our goal is to help you determine where your business is and help you take your business where you want it to go.

Joe Humphreys is associate director of the University of Houston-Victoria Small Business Development Center.



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