How Does Inventory Affect Cash Flow?
The way you manage your inventory has something to do with how much cash your business generates on a daily basis. Inventory can be used to your advantage, but ignorance about how inventory management can affect the movement of cash into or out of your company will definitely be a disadvantage to your business.
Inventory refers to assets that are intended for sale or are in the process of being manufactured for sale. The relationship between inventory and cash is largely determined by your choice of inventory accounting method, the level of inventory you choose to stock, inventory cost and the saleability of your stocks. Efficient inventory management can boost your cash flow, while poor management can cause cash flow problems.
The accounting method that a business decides to use to determine the costs of inventory directly affects cash flow. First-in, first-out, or FIFO, and last-in, first-out, or LIFO, are two of the most commonly used inventory valuation methods. Using FIFO results in a lower cost of goods sold, while using LIFO results in a higher cost of goods sold during times of rising prices or inflation. Your operating profit and net income will be lower due to higher cost of goods sold when you use LIFO, but your cash flow will be higher due to reduced cash taxes.
Stock level pertains to the volume of inventory you maintain for sale. Maintaining more inventory than what is needed for current sales requirements means removing cash from your bank to pay for the extra inventory. Such a move decreases cash in bank and converts the cash into non-cash assets. Managing inventory levels efficiently does not mean stocking more than enough merchandise in your warehouse.
Cost of goods sold refers to the purchase price or production cost of merchandise inventory. The amount you paid to acquire stocks intended for sale can change the amount of cash left in your bank accounts. Introduction of labor-saving technology, cheaper raw materials and eliminating unnecessary overhead are some ways you can lower production cost of inventory. Lower-priced suppliers and cheaper delivery costs are ways to lower inventory purchase cost. The amount of cash that you save by lowering the cost of merchandise goes directly to your bank account instead of the supplier’s bank account.
The type of inventory you maintain greatly affects its saleability. Saleability determines the speed of inventory movement. The more saleable your products are, the faster they move in and out of your stock room. Fast-moving products bring in cash faster than slow-moving ones. The more fast-moving stocks you have, the more cash comes into your cash register.