Of all the resources you should maximize, cash is the most important. More businesses fail for want of cash than for want of profit.
Cash flows in a cycle into, around, and out of a business. Cash goes out for facilities, equipment, labor and materials before cash comes in as sales. That upfront expenditure of cash is usually called working capital. You have a limited amount of working capital. Spend your cash on buildings and maintenance, and there is less to spend on labor. Spend it on material, and you have less to spend on equipment. In good times, you can increase your line of credit to increase your working capital and invest in all aspects of your business. These are not good times.
Buildings and capital equipment are fixed costs, and fixed costs are not easy to flex when business is down. Labor and material on the other hand are variable costs which are more flexible. Most companies do not have an excess of labor. People, unfortunately, are the first to go when the going gets tough. Many companies however do have excess material. Reducing inventory frees up cash, reducing the need to borrow while leaving your critical people in place. Reducing inventory levels relative to sales is the best and least painful way to increase available working capital.
The biggest opportunity for inventory reduction in most companies is to reduce excess inventory. These are parts for which there are future requirements but the balances on-hand exceed the current need. This is different than obsolete inventory which are parts for which there are no future requirements and no recent usage. Reducing excess inventory is not only the biggest but also the best opportunity for freeing up working capital. This is true for several reasons:
- Reducing excess inventories reduces inventory dollars on the balance sheet; so turns, return on assets and all of the financial ratios improve. But unlike scrapping obsolete inventories, there is no negative financial impact from inventory write-offs.
- Reducing excess inventories improves cash flow by deferring incoming purchases until the excess inventory is consumed and replenishment is actually needed. Generally, there is a dollar-for-dollar improvement in cash flow from reducing excess inventories.
- The less excess inventories we have today, the less likely we are to have obsolete inventories tomorrow.
A tool called Inventory Quality Ratio has proven excellent in identifying excess inventories and prioritizing specific part numbers for reduction activities for hundreds of companies in dozens of industries. Whatever tools you use to do so, identifying and eliminating excess inventory is the quickest and best way to maximize the cash flow and free up working capital.
Categorised in: Supply Chain Management