3 Low Cost Sources of Cash – Part 1

Have you ever experienced the stress, strain, and anxiety of not having sufficient cash, thus finding yourself resorting to juggling creditors and even employees to survive?  If so, this blog is for you.

In these tight economic times, nearly every company is concerned with whether they will have access to adequate capital.  In contrast to the past, lenders are scrutinizing borrowers much more closely, and in many cases simply saying “No” to loan requests.  In an earlier blog called The Big 4 Capital Users, I used the acronym CRIP to represent 4 activities that heavily impact cash.  Specifically they are:

C –  Capital Equipment.  (Fixed Assets and their financing)

R –  Receivables (Accounts Receivable along with Credit and Sales Policies)

I –   Inventory (Controls, purchasing policies and procedures, and levels carried)

P –  People (Human resources, employment practices, training, turnover, etc.)

In this list there are three items I think are most often misunderstood, and as a result, small businesses frequently miss golden opportunities to take advantage of internal, low-cost sources of financing.  Instead, they typically try to manage by stretching out payments to vendors and other creditors as much as possible or obtaining a line of credit.  This attempt to compensate produces even more problems; vendors stop shipping, time is wasted trying to explain to creditors when they can expect payment, and lines of credit are used for inappropriate purposes.  Even worse, a line of credit unintentionally becomes what is known as an “Evergreen Loan”,  so-called because it is never paid-off completely.  Perhaps the worst aspect is the previously noted stress, strain, and anxiety the whole situation places on management and employees.  It’s not exactly the ideal way to run a business.

The three items I’m speaking of are (1) Receivables, (2) Inventory, and (3) People.  In this article I will discuss my personal favorite, Inventory.  For now I will leave receivables and people for future discussion.  The fourth item in the Big 4 Capital Users list, Capital Equipment, is in a different category that is not as readily altered to change a company’s cash position.

First, let me say up front that for some businesses inventory represents a small or even no investment.  For example, a service business may or may not have inventory, but may very likely have significant amounts invested in receivables and people.  But, for a company involved in distribution, manufacturing, or retail, inventory is often significant and also overlooked as a ready source of cash.   So, take a look at your financial statements and get the following information.

Step 1 – The average monthly cost of sales (Calculate this by taking the total cost of sales and dividing by the number of months in that cost of sales number).  For example, if you are looking at a cost of sales number for January through May then this cost of sales is for five (5) months, so divide by 5.

Step 2 – Determine the current inventory balance.

Step 3 – Divide the current inventory balance by the average monthly cost of sales calculated in step 1.

Special Note: The actual calculation can get more involved because of freight-in or because of the impact of production costs on inventory as well as numerous other items.  Also, bear in mind that seasonality of sales may impact the accuracy of this number as the cost of sales may vary significantly depending on the time of year.   These factors are beyond the scope of this article.

The result of the above calculation is an approximation of the “Number of Months of Inventory On-Hand“.   If your company is like many small companies, you are very likely to find you have 4 or more months of inventory on hand.  That is, you have enough inventory to sell for 4 months without buying more inventory, assuming you actually had the correct mix of inventory.  It is not uncommon to find companies with 6 to 8 months supply of inventory.

Now, here is where is gets a little more complex, but believe me it is worth the effort.  Go through your inventory and make the same calculation as above, but do it for every item in your inventory.  Your inventory system may already have this calculation done, but if not you can easily do this in an Excel spreadsheet.  Once you have done so, make a note for each item of the time it takes to reorder and receive the merchandise.  If you are a manufacturer, you may need to make some calculation of production time needed to replenish items for finished goods or work-in-process.

Now let me make my point.  To do so, I will assume we are working with a distribution company, but the principles hold no matters what kind of company.  Let’s look at a hypothetical case.  Suppose you can reorder all your products and receive them within a month.  Also, assume that you wish to have a month of reserve on hand (safety stock) for unexpected demand, so that means you need two months of inventory on average.  (For simplicity I will make the assumption that every item sells equally well, and I will ignore seasonality of sales.  In a real situation calculations would be made on an item-by-item basis and seasonality may need to be considered). Now if you find you actually have an average of 4 months of inventory on hand, you now have capital tied up in an extra 2 months of inventory.  Let’s look at an example.  In it we will assume that the average monthly cost of sales is $250,000.

Total Inventory on Hand – 4 Months Supply $ 1,000,000
Total Inventory Needed (2 months, including 1 Month of Safety Stock) $    500,000
Excess Inventory Carried  $    500,000

Okay, there it is.  That $500,000 is the low cost financing that you can use to pay your vendors and other creditors in a timely manner.   Making payments according to terms will get you back in their good graces, and there may well be a time when you need that relationship to be something you can count on.  It actually gets even better.  If you have had to stretch-out your payments, you may have missed the opportunity to take advantage of discounts.  If in the hypothetical company above vendors offered a 2% discount for early payment, that means that each month on average you should realize $5,000 in discounts ($250,000 x 2%).  Over the course of a year that is $60,000.

What could you do with an extra $60,000 in addition to the $500,000 already made available?

How much stress on you and your employees could be eliminated?

How much could you decrease interest expenses?

Of course, the above example is just that – an example.  For simplicity it makes some assumptions.  But I can tell you from my experience it is not far from reality at many companies.  A number of years ago, I had a client that had 7 to 8 months of inventory on hand, and most of their items could be replenished within 2 to 4 weeks.  So, let’s say they needed to keep 2 months on hand to be safe.  That means they had 5 to 6 months of extra inventory.  In the example above, instead of tying up $500,000 in excess inventory, a company would be wasting $1,250,000 (5 months) to $1,500,000 (6 months) in available capital.  To make matters even worse, it may become necessary to make use of a line of credit to finance current operations, and along with that comes interest expense, not to mention stress that is totally unnecessary.

As you can see, this is a real opportunity for small companies to strengthen their financial position using only one internal source of capital.  Yes, it takes some dedicated work to accomplish this, but it is truly worth it.

If you would like some help getting your inventory under control, please do not hesitate to contact us at Contact – AimCFO.

As always, your feedback is welcomed.

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