The Need for Sales and Cash and Inventory Reduction Alternatives - Essay Example

Introduction Over the of the last couple of years many companies have faced some serious cash and inventory related problems, largely as the result of dramatically reduced or even negative sales growth. As a result, cash now represents only 5% of the total asset base for the typical distribution based company. It is a cash position that does not leave a lot of room for error and too much money left sunk in inventory. To offset the cash challenge, most firms have looked at ways to reduce their investment in other major asset categories. One category clearly stand out as being both large and controllable and that is inventor. As a result, serious efforts have been made to drain these assets that are considered as cash traps. While reducing inventory is a laudable effort, the action is fraught with danger. In both cases it is possible, and maybe even likely, that the drive to lower investment levels will trigger further sales declines. This would be because of a higher occurrence of out-of-stock situations. This report will focus exclusively on inventory and cash and in examining the trade-off between maintaining sales volume with a proper and required investment versus having too much money tied up in non-productive assets. It will do that by addressing two key issues: The Need for Both Sales and Cash: An examination of how inventory impacts both the firms cash position and its sales and profitability. Inventory Reduction Alternatives: A review of where inventory can be reduced without impacting sales volume. Literature Review However before proceeding further in this report it is vital to first define what a cash flow statement is. According to Baldwin, Berry, Church & Pitts (2000) the cash flow is a statement of accounts in financial accounting as well as an analytical tool that is used by the management of the organization, the creditors, employees as well as current and future investors to assess the short term viability of the company. The cash flow statement is in three parts and it indicates the affect that changes to the balance sheet and income account have on cash and cash equivalents. The cash flow statement is usually in three parts and indicates the cash inflows and outflows from Operating Activities (Manufacturing and Sales), Investment Activities (Purchase of Plant and Machinery) and Financing Activities (Share issue, debenture issue). While the cash flow statement is one of the statements of accounts that are required by law to be published by all public companies, it is very different from the other statements of accounts like the Balance Sheet, the Profit and Loss Account and the Income Statement. The main difference between these three statements of accounts and the cash flow statement is that the other three statements are prepared on “accrued accounting” basis, while the cash flow statement is cash basis report that does not adhere to the rules of “accrued accounting” (Dresnack, 2006). The balance sheet is the “snapshot” of an organization at one particular point in time and gives the analyst a clear picture of its financial resources as well as its financial obligations. The income statement of an organization on the other hand gives the analyst a clear summary of the financial transactions that have taken place over a period of time (usually one year). Likewise the profit and loss statement too summarizes the activities and the profitability of the company over a period of time (usually one year). And as stated previously all these statements are prepared on “accrual basis accounting”, which matches the revenues (generated income) and expenses that were incurred to generate those revenues (Mills & Yamamura, 1998). On the contrary the cash flow statement is indicates the cash inflows and outflows only and does not show any accruals, but the actual changes taking place to cash balance and cash equivalents. Transactions that do not have any direct affect on cash receipts and payments are not included in the cash flow statement – transactions that are not included in the cash flow statement would be credit sales, credit purchases, depreciation etc. The liquidity of the organization, its solvency in the short term and its ability to change its circumstances in terms of cash flow in the future (“Help Clients”, 2004). It is able to indicate the timing of the future cash inflows and outflows (Rujoub, Cook & Hay, 1995) It is able to provide information on the changes taking place to the assets, liabilities and equity in the company (Mccrea, 2002) It allows for analysis and comparison of the company’s performance against other similar companies in the industry and eliminates the differences that affect reporting when companies adopt different accounting methods – this is because all companies prepare cash flow statements in a similar manner even though they may adopt different accounting methods (Mills & Yamamura, 1998). In the recent past there have been many instances of controversy surrounding the published cash flow statements of organizations. Usually these controversies have been quite severe since the last credit crunch and different creditors to firms have had differing opinions regarding the order in which they should be paid and the manner in which it is or is not reflected in the cash flow statements. Some creditors have been of the view that the most senior credit should be eliminated first, while others have been of the opinion that the highest or the most expensive creditors should be paid off first thus bringing to light a discrepancy in the manner in which different firms report and allocate funds for the different creditors (Carroll & Griffith, 2001). In the United Kingdom, cash flow statements are very important and all public companies are stipulated to publicize their cash flow statements (Vogt & Vu, 2000), this is a requirement under the companies act and indicates the importance that is laid on the statements (Kirkegaard, 1997). Findings The Need for Both Sales and Cash Every firm needs sales to survive. It also needs cash to pay its bills. While these two concepts usually go hand in hand, sometimes they do not. To understand the trade-offs between the two, it is useful to look at the typical financial results of a company. For example if a company has the following Net Sales: $18,250,000 Net Profit Before Taxes: $478,000 - 2.6% sales Total Assets: $3,525,450 Inventory: $1,345,500 or 38 % of total assets Cash: $80,250 or 0.5% of total assets Clearly, the magnitude by which inventory dwarfs cash suggests some major opportunities for reallocation of assets. If the firm could reduce its inventory by 10.0%, which is certainly within the realm of possibility, then cash on hand would be increased by 20%. From a cash flow perspective it is an attractive, and possibly even essential, shifting of funds. At the same time, even a modest 5.0% reduction in inventory has the potential to lower sales volume, if the reduction lowers the firm’s service level. Exhibit 1 examines the challenges associated with an inventory reduction by looking at current results and three different scenarios. Net Sales Cost of Goods Sold Gross Margin Total Expenses Profit Before Taxes Percentage Change in Profit Percentage Change in Profit Inventory Inventory Inventory Reduction Inventory Turnover Current $13,000,000 $9,360,000.00 $3,640,000.00 $3,367,000.00 $273,000.00 $1,766,038 $1,766,038 5.3 No Impact $13,000,000 $9,360,000.00 $3,640,000.00 $3,353,755.00 $286,245.00 $13,245 4.90% 4.90% $1,677,736 $1,677,736 $88,302 5.6 2% Sales Decline $12,740,000 $9,172,000.00 $3,567,200.00 $3,353,755.00 $213,445.00 ($59,555) -21.80% -21.80% $1,677,736 $1,677,736 $88,302 5.5 5% Sales 5% Sales Decline $12,350,000 $8,892,000.00 $3,458,000.00 $3,353,755.00 $104,245.00 ($168,755) -61.80% -61.80% $1,677,736 $88,302 5.3 The first column of numbers merely reviews the results for the typical firm. The second column explores a 5.0% reduction that, through either luck or great planning, actually is achieved with no impact on sales. The result is that inventory is reduced by $36,153, which increases cash by the same amount. With no sales reduction, the top half of the income statement remains intact. The reduction in inventory is accompanied by a reduction in inventory carrying costs, which increases profits. This represents the perfect world towards which inventory reductions are always aimed. The ability of the typical firm to reduce inventory by 5.0% with no negative sales consequences is problematic. The third column of numbers builds a scenario in which the 5.0% reduction in inventory results in sales declining by 2.0%. This is merely illustrative, as the exact impact of an inventory reduction on sales would obviously vary from company to company. Even with a very modest sales decline, the impact on profit is severe. The reduction in inventory carrying costs is more than offset by the drop in sales and drives profits down to $154,868, a 18.1% decline. From a profit perspective, sales is much more important than the inventory reduction. Finally, in the last column of numbers, if a 5.0% reduction in inventory were accompanied by an equivalent 5.0% decline in sales, the results would be disastrous. Profits fall to only $95,536, a reduction of 49.5%. At this point, the entire effort to reduce inventory in order to make gains in the cash flow position has been wasted. Clearly, the economics of the firm overwhelmingly favor maintaining sales volume. In particular, some of the more panic driven approaches to inventory management, such as cutting inventory across the board, are doomed to failure. At the same time, most firms need to strengthen their cash position and inventory remains an appealing alternative. The challenge is to find a way to make the inventory reduction and maintain sales levels too. With some level of patience, that is actually an attainable objective. However, it is not attainable in such a way that it provides an immediate cash transfusion to the firm. Inventory Reduction Alternatives Reducing inventory requires both a realistic goal and a specific methodology. For a goal, the 5.0% reduction used earlier is a reasonable undertaking. For the vast majority of firms, goals in excess of that number are probably not achievable without creating major sales problems for the firm. Even the 5.0% figure requires the firm to proceed with caution. In order to reach even a 5.0% reduction without a sales loss, it is necessary to break the inventory investment into pockets of opportunity. The results of such an analysis are presented in Exhibit 2. Since such information is not routinely collected for the industry, this exhibit needs to be viewed as illustrative. Most firms will follow fairly closely, but a few may depart dramatically. Category A B C D Total Percent of SKUs 10 10 30 50 100 Net Sales $ $7,800,000.00 $2,600,000.00 $1,950,000.00 $650,000.00 $13,000,000.00 Percent 60 20 15 5 100 Inventory $ $706,415.00 $353,208.00 $353,208.00 $353,208.00 $1,766,039.00 Percent 40 20 20 20 100 Inventory Turnover 8.6 5.3 3.4 0.6 5.3 The exhibit takes the widespread approach of dividing the firm’s SKUs into A, B, C and D sales volume categories. The A items, which are the fast sellers, represent only about 10.0% of the SKUs but provide 60.0% of the sales volume. They are where the sales action is. The B items are generally another 10.0% of the SKUs and contribute another 20.0% of the firm s sales. This relationship is consistent with the age-old 80/20 rule which is well understood in distribution. To continue with the 80/20 rule line of reasoning, the C items are about 30.0% of the SKUs, while providing only 15.0% of the sales. Finally, the D items are around 50.0% of the SKUs, but generate just 5.0% of the sales. The 80/20 rule is so well known that too many firms don t even think about it any more. As a result, they tend to overlook it in their planning. The concept needs to be given new attention, especially when it is expanded to consider the inventory investment required to generate the sales. The columns toward the right of the exhibit indicate that while the A items account for 60.0% of the sales, they absorb only 40.0% of the overall inventory investment. The result is that they have an inventory turnover level that is far above that produced by the total firm. In contrast, the B items achieve almost exact parity, with 20.0% of the sales coming from 20.0% of the inventory investment. Their rate of inventory turnover is almost always exactly equal to the turnover for the firm overall. Both of the remaining categories require proportionately more inventory than sales. At the C level the problem is significant, while at the D level, the inventory imbalance is nothing short of critical. Any effort at inventory reduction should be aimed at the D items with some support from the C items. The problem is that the inventory on the A items can be reduced quickly as they sell in large quantities. However, this is where out-of-stock problems will arise with the greatest severity. At the other extreme, reducing the inventory on D items is a slow, almost agonizing process. It is at this level, though, where the inventory reductions are generally painless from a sales loss perspective. In order to drain the inventory cash trap it is necessary to set some sub-goals for inventory reductions. Assuming that a 5.0% overall reduction continues to be realistic, the firm should probably think in terms of the following: A Items: No reduction B Items: No reduction C Items: 5.0% reduction D Items: 10.0% reduction Over time, this will produce the inventory reduction required to generate more cash. Given that too many of the D items are redundant, duplicate items in the assortment, there should be little, if any, sales loss. The payout, alas, will come slowly rather than quickly. Conclusion It is absolutely essential that firms avoid any inventory reductions that impact sales. Given current cash levels, quick inventory reductions are a tempting short-run expedient. They are also a long-run impediment to success. The firm would be better served to set specific targets for slowly eliminating redundant items from the assortment. It is a process that should not be abandoned when economic conditions improve. It should be a strategy for all seasons. References 1. Baldwin, T. J., Berry, R. H., Church, R. A., & Pitts, M. V. (2000). Cash Flow and Corporate Finance in Victorian Britain: Cases from the British Coal Industry, 1860-1914. Exeter, England: University of Exeter Press. 2. Carroll, C., & Griffith, J. M. (2001). “Free Cash Flow”, Leverage and Investment Opportunities. p. 141. 3. Dresnack, W. H. (2006). “Creative Cash Flow Reporting: Uncovering Sustainable Financial Performance”. Issues in Accounting Education, 21(2), pp. 159. 4. “Help Clients Create a Positive Cash Flow”. (2004). Journal of Accountancy, 197(3), pp. 28. 5. Kirkegaard, H. (1997). Improving Accounting Reliability: Solvency, Insolvency, and Future Cash Flows. Westport, CT: Quorum Books. 6. Mccrea, B. (2002, July). “Going with the (Cash) Flow: Entrepreneurs Can Look at These Strategies to Help the Bottom Line”. Black Enterprise, 32, pp. 40. 7. Mills, J. R., & Yamamura, J. H. (1998). “The Power of Cash Flow Ratios”. Journal of Accountancy, 186(4), pp. 53. 8. Rujoub, M. A., Cook, D. M., & Hay, L. E. (1995). “Using Cash Flow Ratios to Predict Business Failures”. Journal of Managerial Issues, 7(1), pp. 75. 9. Vogt, S. C., & Vu, J. D. (2000). “Free Cash Flow and Long-Run Firm Value: Evidence from the Value Line Investment Survey”. Journal of Managerial Issues, 12(2), pp. 188. Read More