All transactions that occur within an organization impact the cash flows of that company. Some transactions require cash outflows, or the spending of cash. Other transactions require cash inflows, or the receipt of cash. Inventory incurs both cash inflows and outflows for the company. Cash inflows occur when the company sells the inventory. Cash outflows occur when the company purchases the inventory. As long as the company holds the inventory, its cash remains tied up with the inventory investment. Companies calculate the cash flows tied up with inventory in order to manage their inventory levels.
Items you will need
- Current year balance sheet
- Prior year balance sheet
Locate the current year inventory balance from the balance sheet. The balance sheet lists each asset owned by the company, including inventory. The company classifies inventory as a current asset, or one that will convert into cash within one year. Review the current asset section of the balance sheet to find the inventory balance. The total inventory may include several balances, such as finished goods, raw materials or work in process.
Locate the prior year inventory balance. Using the prior year’s balance sheet, locate the inventory balance. This amount appears in the current asset section, similar to the current year’s balance sheet.
Calculate the difference in inventory balances. Subtract the current year’s inventory balance from the prior year’s inventory balance. This provides the dollar amount of cash flow generated by the change in inventory.
Determine if the inventory increased or decreased. If the current year’s inventory balance is higher than the prior year’s inventory balance, the inventory increased. If the current year’s inventory balance is lower than the prior year’s inventory balance, the inventory decreased.
State the cash flow from change in inventory. This includes stating both the amount of change and whether the inventory increased or decreased. If the inventory increased, the company experienced a cash outflow. If the inventory decreased, the company experienced a cash inflow.
While companies use cash flow calculations to manage inventory levels, they also need to consider the saleability of the inventory. Inventory items which remain with the company for extended lengths of time run the risk of becoming obsolete or declining in value. This calculation does not consider how long the company owned the inventory.