Inventory is often one of the largest components of a company’s assets, and controlling it is a critical step in managing company cash flow. An entrepreneur takes a risk in spending cash. If you buy inventory, you run the risk that no one will buy it at a price that will give you a profit or even buy it at all. When you invest in inventory, cash is tied up and cannot be used for other purposes, such as rent, payroll, and debt service. By managing the level of inventory on hand, you will be dealing with one of the three primary controllable factors in cash availability.
There are two other risks involved with inventory—storage costs and pilferage, which is theft of inventory. You will have to be sure you can sell the inventory at a price that will include the cost of storing it and cover pilfering. Barneys, the famous New York clothing store, eventually had a 7 percent pilferage rate, which helped drive the company out of business (although it made a comeback later). Remember to account for these inventory-related costs in your projections.
You should also be cautious about adding inventory based on the expectation of receiving cash from the customers who owe you money. Because a percentage of the receivables owed to you may never be collected, counting on getting all of the cash could cause liquidity problems. You must keep track of your cash flow, or you can get caught in a squeeze between your suppliers, who want you to pay for the inventory you have purchased, and customers who have not yet paid for what they bought. If you cannot pay your creditors, you could lose ownership of your business. That’s what happened to Donald Trump and the Taj Mahal in Atlantic City some years ago. He couldn’t pay his loans, so he had to turn over 80 percent ownership in the casino to the
Conceptually, it is clear that reducing inventory releases cash. However, reducing inventory once accumulated is generally easier said than done. If it is finished-goods inventory, it has to be liquidated—sold—if it is to be converted into cash. This often means discounting products in ways that are not in alignment with your overall pricing strategy. If, inventory is in the form of work-in-progress or semi-finished goods, additional materials and labor costs may have to be invested to make it ready to sell. Thus, freeing up cash by reducing inventory is a valid option that can work but should be carefully considered and realistically projected. The LSBF is the best source to learn more about business and cash management.