Smart Inventory Solutions. Phillip Slater
all the cash that goes out (buying raw materials, spares, utilities, labor, overheads, investment, dividends, interest, and loan payments) and the money that comes in (receipts from customers).
Figure 3-2: The Cash Flow Cycle
If the cash flow is negative, that is, the ‘cash in’ is less than the ‘cash out’, the company will need to borrow more money or it will be unable to buy supplies, labor, utilities, etc. As mentioned previously, no cash, no business. If the ‘cash in’ is greater than the ‘cash out’ then the cash flow is said to be positive. The business will have excess cash it can then invest or use to repay borrowings.
Here is where materials and inventory management comes in: if a company is able to reduce its level of inventory, it can free up the cash that is invested in the buffers between suppliers, production, and customers. This improvement then reduces the ‘cash out’ and helps provide a positive cash flow. The extra cash can then be used to pay back borrowings and reduce interest bills or it can be used for further capital investment, without borrowing more money. This is the most effective way for a company to manage its cash — free up the cash that it has already invested in itself.
Minimizing the investment in inventory is good business practice for all companies as they improve cash flow. It produces both an increase in cash and an ongoing reduction in costs. Table 3-1 shows how reducing inventory has a positive impact on the key business measures of cash flow, ROFE (Return on Funds Employed), and EBIT.
There are a number of actions that can be taken to reduce inventory; these are discussed in detail in Chapter 8. However, to demonstrate the cash effect, Table 3-2 shows some of the generic actions that can be taken and their specific business impact. The key point to remember is that ‘cash is king’ and that excessive inventories are an unproductive use of cash.
| Business Measure | Impact of Reduced Inventory |
| Cash Flow | • Reduces the outflow of cash because items are not purchased for restocking• Delays expenditure until an item is more likely to be needed• Frees up cash for other uses such as capital upgrades or repaying borrowings |
| ROFE | • By reducing the investment base, the return on funds employed (ROFE) increases• By increasing ROFE, the company becomes a more attractive investment• The impact of this change is likely to be an increase in share price |
| EBIT | • By freeing up cash to pay back borrowings and/or minimizing the amount of borrowings, the company saves on interest payments and holding costs. This adds directly to the company’s earnings |
Table 3-1: The Impact of Reduced Inventory
| Example Actions | Impact |
| Remove obsolete stock | • Scrapping stock will provide a tax benefit in most countries.• Sale of items will provide an inflow of cash (and may produce a profit). |
| Reduce reorder stock | • A delay in spending cash retains cash in the business (improving cash flow).• Lower reorder quantities reduce the stock held value and associated costs. |
| Reduce maximum holdings | • Reduces the stock held value and associated holding costs. |
| Remove overstocked items | • If removed by natural attrition, the impact is to reduce the stock held value and associated costs.• If written off, the impact is the difference between held value and revenue if sold. |
| Reduce quantity held | • In addition to the obvious reduction in inventory, the impact will be to reduce the costs of counting, maintaining, moving, storing, etc. |
Table 3-2: Examples of Actions and Their Impact
The Four Financial Reports that You Absolutely Must Understand
Now that you understand the business impact that inventory has on an organization, it is important to understand the financial reporting that relates to inventory. There are four levels of reporting that you absolutely must understand:
1.The Cash Flow Statement
2.The Balance Sheet
3.The Profit and Loss Statement
4.The Operating Statement
Each of these reports relates to financial outcomes. However, the type of expenditure and the time frame that they address vary. Understanding these distinctions is crucial to appropriate materials and spares inventory management.
1.The Cash Flow Statement
As described in the Cash Flow Cycle (see Figure 3-2), businesses have cash that comes in (capital raising, loans, revenue from sales, etc.) and cash that goes out (capital purchases, payments to suppliers, wages and salaries, dividends, etc.). The Cash Flow Statement is simply an accounting of each of these inputs and outputs so that we can readily see where money came from and where it was spent. The Cash Flow Statement typically classifies the transactions in cash flows relating to operating activities, financing activities, and investment activities. Money that is spent on materials and spares will appear on the cash flow statement as an outflow of cash in the ‘operating activities’ section under a title such as Payments to Suppliers.
2.The Balance Sheet
The Balance Sheet is sometimes now referred to as the Statement of Financial Position because it is a snapshot of the financial assets and liabilities of a company. As a snapshot, it describes the state of the business on the day that the report represents. The content of the balance sheet, or at least the items represented and their meaning, is standardized through international accounting standards that form the legal reporting requirements for all companies (although the requirements may vary slightly from country to country).
Materials purchased as inventory will appear on the Balance Sheet as an asset because, in theory, they have a financial value (see Figure 3-3). They could be sold to raise cash (which of course is what happens with raw materials, WIP, and finished goods inventory). When the inventory materials are purchased, their cost is recorded against a ‘capital account’ which is like a cost center or cost code for balance sheet items.
Figure 3-3: Example of the Asset Section of a Balance Sheet
Although companies can generate a balance sheet at any time, they are typically produced (or published) twice a year: the fiscal midyear and fiscal year end reporting. From this we can see that, if the inventory on the balance sheet is only reported twice a year, it may only get highlighted and receive attention twice a year. Is it any wonder then that it becomes the forgotten investment! When accountants comment that a company holds too much inventory, they are typically referring to the value on the balance sheet rather than the physical holdings of any specific item.
3.The Profit and Loss Statement
The Profit & Loss (P&L) Statement is sometimes now referred to as the Statement of Financial Performance. Although the Balance Sheet shows the state of affairs at a particular point in time, the P&L compares income with expenses over a period of time. This could be a month, quarter, or year.
The P&L does not include Balance Sheet items such as property, plant and equipment, and other assets, such as inventory. This is because the money spent on capital items and inventory is expected to be consumed over several (or many) reporting periods, rather than in one period. The attribute that it is not used in the same period in which it is purchased is an important factor for identifying inventory. Thus, the P&L does not record the level of inventory held or, overtly,