Session 6 & 7: Cash Flow Forecast
Inventory
Inventory consists ofthe goods and materials a company purchases to re-sell at a profit. In the process, sales and receivables are generated. The company purchases raw material inventory that is processed (aka work-in-process inventory) to be sold as finished goods inventory.
For a company that sells a product, inventory is often the first use of cash. Purchasing inventory to be sold at a profit is the first step in the profit making cycle (operating cycle) as illustrated previously. Selling inventory does not bring cash back into the company — it creates a receivable. Only after a time lag equal to the receivables collection period will cash return to the company. Thus, it is very important that the level ofinventory be well managed so that the business does not keep too much cash tied up in inventory, as this will reduce profits. At the same time, a company must keep sufficient inventory on hand to prevent stock outs (having nothing to sell) because this too will erode profits and may result in the loss of customers.
The correct level of inventory is a function of the length ofthe company's inventory cycle and the company's sales level. A company's inventory cycle is divided into three phases:
- The ordering phase,
- The production phase, and
- The finished goods/delivery phase.
The ordering phase is the time it takes a company to order and receive raw materials. The production phase is the time it takes to produce finished goods from raw materials. The finished goods/delivery phase is the amount oftime finished goods remains in stock and the delivery time to a customer. The inventory cycle in days is determined as follows:
Inventory Cycle In Days = Ordering Phase in Days + Production Phase in Days + Finished Goods and Delivery Phase in Days
Example: Inventory Cycle
Now let's look at an example of how a small business might use this information to plan its purchases and manage inventories. The ABC Company is a producer of specialty pottery vases. The company imports clay from the Big Timber Landfill. Ordering and receipt of the clay generally takes 14 days. If the company orders clay today, it will receive the clay in 14 days. To prevent stock outs, the company reorders whenever clay inventories drop to 14 days. Once in the shop, the clay base is mixed with water and rests one day to set up to the proper texture. It takes one day to spin the vase, three days to dry, one day to paint and one more day to dry. The production cycle from wetting clay to drying the paint is seven days. Because it takes seven days to produce seven days worth of sales, the company never lets its stock of vases shrink to less than seven days worth of sales. The delivery phase is very short because most of the product will be delivered in the immediate area. Management estimates that delivery takes one day at most. The company's minimal inventory cycle is 22 days:
Inventory Cycle In Days = 14 days for ordering + 7 days for production + 1 day for delivery
If clay is ordered today, a vase made of that clay can be delivered to a customer no sooner than 22 days from now. Now let's also assume that Company management likes to keep an additional five days of inventory on hand as a cushion to cover any delays in receipt of the clay and production of the vases. Therefore, the company's total inventory cycle is 27 days. To keep the cycle running smoothly, the company must keep its investment in inventory equal to 27 days worth of sales. The company must keep an investment in inventory equal to its inventory cycle. If ABC keeps only 15 days' worth of investment in inventory, it eventually will run out of stock because clay ordered today cannot be delivered as a vase for 22 days.
We have learned that this investment requires the use ofcash. Thus in the above example, ABC must have sufficient cash to acquire at least 22 days ofinventory, and that management operates more comfortably with 27 days' sales in inventory. Knowing this, we can estimate the dollar ($) amount of inventory as follows:
Minimum Investment in Inventory (in $'s)=
Inventory Cycle In Days X Cost of a Day's Sales (in
$'s)
The investment in inventory will vary according to both the sales per day and the length of the inventory cycle in days. As sales rise, the amount of inventory sold daily rises and the investment in a day's worth of inventory must increase or stock outs will eventually occur. As the inventory cycle lengthens more inventory must be kept on hand to produce the same level of sales and the investment in inventory mcreases.
Just as we measured the "quality" of accounts receivable, another ratio can be used as an indicator ofthe "quality" of inventory. We do this by comparing the actual inventory level to the inventory cycle. Insufficient inventory indicates potential stock outs, Excessive inventory may indicate, stale inventory, poor inventory controls, or fudging (miscounting).
To measure quality, the actual number of days of inventory on hand is measured as follows:
Days In Inventory = Actual Inventory x 360
Cost of Good Sold per year
Ideally, inventory will be at a level slightly greater than the inventory cycle.
Days In Inventory Inventory Cycle In Days