Understanding the Relationship Between Inventory & Cash Flow

If the incoming cash is less than the cash going out of your business, it impedes the growth of your venture. A healthy cash flow is imperative for your ability to pay employees and suppliers. Without inventory and people, there will be no business left to operate.

Consider, as an example, that you own a gumball machine. Buyers insert a quarter and receive a gumball in return. But what happens if the machine starts spitting out candy when buyers insert only a dime, or a penny. Eventually, this negative cash flow will impact your ability to refill the machine.

As a business owner, you should always be aiming to maintain a positive cash flow. What’s the one thing that can help you achieve that? Effective inventory management! This guide will shed light on the relationship between inventory and cash flow and will offer tips on maintaining a positive cash flow through smart inventory management tactics.

 

Why Does an Increase in Inventory Decrease Cash Flow?

 

To understand how inventory and cash flow are interrelated, you first need to know what the negative amount in a cash flow statement means. On the statement of cash flows (SCF), the negative amount indicates:

 

  • A cash outflow
  • Unfavorable expenses impacting your business’s cash balance
  • Use of company’s cash

 

When you purchase more goods to stock in your inventory, you need cash. An increase in inventory thus leads to an outflow of cash. If you buy additional goods than what’s actually needed, it will hurt the overall cash balance. 

 

These are reported on the SCF as negative amounts. The opposite is also true. A decrease in inventory has a positive impact on your business’s cash balance. On the SCF, it is reported as a positive amount.

 

How is Inventory Reported in the Cash Flow Statement?

 

Towards the end of a financial year, businesses generally have unsold commodities stored in their warehouses. These are called stock-in-trade or closing inventory. The income statement does not account for closing inventory.

The statement of financial position, however, reflects this. Apart from that, the stock-in-trade also influences the cash flow statement.

 

Inventory in Cash Flow Statement

 

The annually prepared cash flow statement is audited along with the statement of financial position, as well as the income statement. These statements detail how a company’s cash is managed throughout the year. According to most financial reporting frameworks across the globe, the cash flow statement consists of three main categories:

 

  • Operating activities
  • Financing activities
  • Investing activities

 

Changes in inventory are reported under the operating activities on the statement of cash flow.  Increase in stock-in-trade is deducted from the profit or loss statement before taxes. On the other hand, a decrease in closing inventory is added to the annual profit or loss before taxes.

 

Does Your Accounting Method Have Any Impact?

 

In short, yes! Your accounting method has a direct impact on the cash flow of your business. The most common accounting methods (or inventory valuation methods) are LIFO (last in, first out) and FIFO (first in, first out). 

 

The former lowers the cost of commodities sold while the latter increases the cost of goods sold. If you’re using LIFO, your net income and operating profit will be lower because of the higher cost. Because of reduced cash taxes, however, your business’s cash flow would be higher.

 

How Does Type of Inventory Affect Cash Flow?

 

The salability of your inventory largely depends on its type. It also determines the speed at which your commodities move into your stock room and move out. The greater the saleability, the faster the inventory movement. Fast-moving goods thus bring more cash into your business, compared to slow-moving ones.

 

Stock Level

 

Besides the type of inventory, the stock level also plays a crucial role. Stock level refers to the volume of inventory maintained by a business. If you maintain more inventory than your sales requirements, you’re removing cash from your business to pay for those extra goods or commodities.

 

This strategy lowers your bank balance and converts your cash into non-cash assets. Efficient inventory management necessitates that you don’t stock more than what’s needed in your warehouse. 

 

Consider investing in inventory management software to avoid understocking or overstocking. Tracking it manually can quickly get overwhelming, especially if you’re operating a large business.

 

Cost of Inventory

 

The purchase price of your commodities directly affects your business’s cash balance. To maintain a healthy cash flow, you need to lower the production cost of your inventory. 

 

Eliminating unnecessary overhead, investing in labor-saving technology, and partnering with lower-priced suppliers are some ways to do that. By decreasing the cost of commodities, you save cash that reflects in your bank account rather than your supplier’s.

 

The Bottom Line

 

Inventory management can work in your favor. By incorporating the right accounting method, maintaining an accurate stock level, lowering the production cost, and choosing fast-moving inventory, you can maintain a positive cash flow. This will bode well for the sustainability of your business!

 

 

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