“My accountant said I made a profit this year. But where’s the cash?”
This would have to be the number one question I get asked by business owners and entrepreneurs. Where is my cash flow?
When assessing the financial performance of a business, most people – accountants and business gurus alike – will usually refer to profit as a key indicator of financial success.
Here’s why that’s misleading.
In this article:
The relationship between profit and cash flow
Profit is not the same as cash flow, and the difference between them can be explained by the movements in your balance sheet.
Your profit is skewered by accounting adjustments for the treatment of certain types of expenses (like capitalising assets), as well as changes in working capital.
This is particularly true for eCommerce businesses, because most of your cash is tied up in inventory.
Managing your inventory is a science. By far the most critical aspect of running a successful online business, inventory management takes data and an acute understanding of the market to get the balancing act of purchases just right.
When you carry too much stock, your cash becomes tied up, and you’re missing out on capital that could otherwise be used to fund the rest of your business. This cash flow problem can be compounded if your product is perishable or depreciates quickly – every day you hold onto it, it loses its value.
In a worst case scenario, you could be left with no cash and no product.
On the flipside, if you carry too little stock, you might run out and have nothing to sell to your customers. This can cripple your future sales, as your revenue is obviously hamstrung until you can be restocked.
How to measure your inventory
One approach to managing this fine balancing act is by measuring metrics like stockturn and inventory days. To understand how long your inventory is sitting in your warehouse doing nothing, follow this formula:
INVENTORY DAYS = INVENTORY VALUE / MONTHLY COST OF GOODS SOLD x 30
The goal is to make your inventory days as low as commercially possible. In essence, the lower the inventory days, the faster you are converting your inventory to cash. It’s like a game of golf, where the aim is to get the lowest score possible.
Aim for lower inventory days
The average number of inventory days varies between industries and depends on the product type and business model. For example, companies that sell perishable or fast-moving products like food will have a lower inventory day benchmark than businesses selling non-perishable or slower-moving products, like cars.
Tim Cook, CEO of Apple, famously quipped:
“Inventory is fundamentally evil. You kind of want to manage it like you’re in the dairy business. If it gets past its freshness date, you have a problem.”
In other words, irrespective of what you sell, you should treat your business as if everything has a shelf life.
In 2017, Apple’s average inventory was a mere 11.18 days – an enviable figure given that the benchmark for consumer tech is 30 days. If your inventory days are higher than the benchmarks, consider ways you can reduce them.
As a general rule of thumb, unless your product is particularly perishable, if your inventory days are around 30 days, you’re doing pretty well. If it’s any higher than that, explore ways you can reduce them by being more strategic with your purchasing decisions.
Remember, lower inventory days result in more cash. This is one more goal you can strive for to achieve operational excellence.
Get rid of excess stock
There are two common culprits behind bloated inventory balances – obsolete and slow-moving stock. These are the products that have become dated because a newer, shinier version has been launched in the market. This is especially true if your business is subjected to trends and seasonality, like fashion.
There are a number of ways to figure out what stock needs to be written-off.
Look at stock reports
For a data-driven approach, generate a stock report from your inventory management system and filter the data to identify the last sale date. If the time period from your last sale date of a product to today’s date is greater than your Inventory Days metric, assess whether that product can be sold at a discount price, or at worst case written off completely.
Sync your inventory management with your accounting system
We recommend using an inventory management system that integrates alongside your accounting software stack. This will take a lot of the guesswork out of inventory control.
If your eCommerce business seems to be eating cash, keep a close eye on your inventory cycle – it could be costing you more than you realise.