In this tough economy, business owners must find ways to increase their cash flow. Many will concentrate on increasing profits by growing sales, improving gross profit and reducing expenses. That’s a good starting point, but increased profits do not necessarily translate into more cash in your bank account.

For most firms that sell products, the three major components of working capital are inventory, accounts receivable and accounts payable. Here are a few tips that I used for over 20 years as a consumer products wholesale distributor:

The goal is to stock the minimum amount of inventory without negatively affecting sales. In other words, you want the highest fill-rate possible using the smallest inventory possible. Inventories in excess of the needs of the business tie up funds that could be used in other ways to better advantage and may increase the amount of insurance, storage and other expenses. There is also added risk of loss through price declines and deterioration or obsolescence of the merchandise.

A good place to start when analyzing a firm’s level of inventory is a key benchmark indicator, the Inventory Turnover Rate – The Inventory Turnover Rate is computed by dividing the cost of goods sold by the average inventory:

                                                                           2010                2009

Cost of goods sold                                             $1,043,000        $820,000

Inventory:                                 

   Beginning of the year                                       $    283,000       $311,000

   End of the year                                               $    264,000       $283,000

   Average                                                              $273,500       $297,000

Inventory Turnover Rate                                                   3.8                 2.8

The improvement in the turnover resulted from an increase in the cost of goods sold, combined with a decrease in average inventory. If the Inventory Turnover Rate in 2010 was 2.8, like 2009, the average inventory in 2010 would be $372,500. Therefore, the increased rate of inventory turnover in 2010 freed up $99,000 in funds.

What constitutes a satisfactory Inventory Turnover Rate? It depends on the type of business and the type of merchandise. For example, a firm selling fresh food should have a higher turnover than one selling furniture or jewelry, and the perishable foods department of a supermarket should have a higher turnover than the soaps and cleaners department.

In most businesses, the 80/20 rule applies….20% of the items in your inventory, generate 80% of sales. Customers will be happy and consider you a reliable supplier if your “fill rate” on these items is 98%-100%. Anything less and they will seek another supplier. On the other items that comprise 80% of your inventory, the customer will be a little more forgiving if you are out of stock

Things to consider in fine tuning your inventory levels:

• Once you submit a purchase order to a vendor, how long does it normally take to receive the order?
• Does the vendor have a high “fill rate”?
• Does the vendor offer “free freight” for purchase orders exceeding a certain amount?
• Are products perishable?
• If you discontinued some of a vendor’s products, what will be the effect upon sales? e.g., if you don’t carry an item, will customers do business with your competitors?  If a customer wants $20 worth of an item you no longer stock, would you lose an order from the customer for $500 which includes other items you sell? If so, it may be worth stocking a limited amount of the slow moving item.

Charlie Yacoobian, CPA is a partner in the firm B2B CFO®, offering comprehensive, long-term, part-time CFO services to small and mid-size businesses and can be reached at (661)714-2588 or cyacoobian@b2bcfo.com.