According to one report I recently read, 38% of businesses fail because they run out of cash. All companies are dependent on cash flow. But managing money is not a skill that all small business owners have. Some entrepreneurs are visionaries, while others are more focused on business growth. If you want your business to become profitable, keep your eye on the bottom line. Every dollar you spend is ultimately taken away from your profit margin.
When it comes to strategic financial planning, few approaches are as important as reducing the company’s inventory & receivable financing costs. When a company looks at its financing costs of inventory, it is really concerned with its daily cost of money. Even after the product has been invoiced, the company will continue to cover this daily cost of money for everyday their receivable goes unpaid. This is why a number of companies only consider a sale finalized once the invoice has been paid. However, just how impactful are these financing costs? More importantly, how does a company reduce its inventory & receivable financing costs?
To answer this question, it’s best to understand the company’s financing costs of inventory and its financing costs on receivables. Start by defining the company’s daily cost of money and its impact on the company’s costs to finance its inventory and its receivables. After all, the company must pay a daily interest rate for every day they hold inventory and don’t sell it, and they must also cover this daily rate for every day their customer’s invoice goes unpaid.
To illustrate how this is done, consider the following examples of a company who finances their inventory and receivables with a 9% yearly interest rate. This first step is to determine the company’s daily interest rate in order to determine its daily cost of money. This would be this 9% divided by 365 days in a year. This gives us 0.0247%. The second step would involve calculating this daily rate by the product’s COGS. Doing this gives us a $6.65 cost of money. Finally, multiply the company’s daily cost of money ($6.65) by the number of days the inventory is held before it’s sold. Over 90 days, these costs become $599.17.
Step 1: Determine daily interest rate
Step 2: Multiply daily interest rate by COGS
Step 3: Multiply daily cost of money by number of days inventory is held
Financing Costs of Inventory:
Doing the exact same calculation on the company’s receivables over 45 days, and the costs increases by $399.45. In this case, holding product for 90 days before selling it, and then waiting a further 45 days before getting paid, means the company’s total cost to support the transaction was 998.62! Receivables
Financing Costs of Receivables:
Simply put, if you can reduce the amount of time you hold inventory, and speed up the time it takes your customers to pay, then you’ve effectively reduced your inventory and receivables financing costs. Now, obviously this is much easier said than done and by no means am I implying that this pursuit is easy. It isn’t. However, it is easier once you’ve outlined your company’s daily cost of money and have demonstrated its impacts on your inventory costs and your costs to financing your receivables. Once you’ve done that, you can then enact best business practices aimed at reducing these financing costs. So, what are some of the strategic planning initiatives your company can pursue?
Aggressively Sell Slow Moving Inventory:
You must incentivize your sales team to aggressively sell slow moving inventory. Sometimes this requires discounting this inventory, liquidating it at a much lower price or providing customers with incentives to purchase like net-10 day terms 1% discount on invoices. However, in other instances it involves covering your company’s financing costs of inventory by penalizing the entire sales team for slow moving inventory. Sounds harsh? It isn’t. Sales forecasts inventory and therefore they must play a more proactive role in reducing its costs.
Speed up Inventory Turnover Rates:
Sometimes the easiest solution to holding inventory is not to hold it at all. Bottom line, if your company is holding inventory for extended periods, then you’re either not doing a good job selling that product or you shouldn’t be selling that product. To resolve this issue, take the time to review the product’s strengths & benefits to your company and from the perspective of your customers. However, until you’ve figured out what’s wrong, it’s best to move these product lines to “made-to-order” status only.
Match Inventory to Business Model:
Are you continually chasing your own tail when it comes to inventory? Do you find that you either have too much or too little inventory? If you’ve answered yes to both of these questions, then you’re probably running the wrong inventory management strategy. The one rule of inventory management that all companies must follow is to match their supply chain strategy to their customers’ order patterns, the needs of their market and finally, to their business model. Don’t go with something you’ve read works for other companies in other markets. Instead, define your business and use an inventory strategy that meets your needs.
Bridge the “Gap” Between Inventory & Sales:
It’s important to understand that your sales and inventory departments typically have divergent or contradictory goals and objectives. Inventory is often tasked with reducing inventory holding costs and that often means to reduce the amount of inventory the company retains – although low inventory rarely means low costs. On the other end of the spectrum is the sales team. Sales is incentivized to sell inventory and when there’s little to no inventory, there’s often little to no sales. To improve how these two departments function, think about using an Inventory Asset Manager.
Pursue Prompt Payment, Prepayment & Invoice Discounts:
Now that you’ve seen just how expensive it is to finance a company’s receivables, pursuing strategies that speed up payment should be a number one priority. Surprisingly, these initiatives aren’t that difficult. Given the choice, a number of customers will opt to get a discount or price reduction for prompt payment on invoices. Don’t be afraid to offer net-10 day terms or to pursue those “less than stellar” customers with bad credit. Customers that prepay their orders help to eliminate your company’s daily cost of money.
Pursue Alternative Financing Options:
Despite very competitive interest rates, every company’s financing costs have skyrocketed. How is this possible? Simply put, regardless of how competitive interest rates are, if customers aren’t paying on time, are going bankrupt or are extending their terms, your company’s costs will increase. To offset these costs, it might be time to start investigating alternative financing options like purchase order financing and accounts receivable factoring. Both options dramatically improve cash flow and reduce your financing costs by advancing you cash so you no longer have to wait for your customers to pay.
Adopting strategic planning initiatives to reduce your inventory & receivable financing costs simply amounts to understanding how these costs affect your gross profit. Start by defining your daily cost of money and its impact on your inventory holding costs. Next, define its impact on your company’s costs to support its receivables.
Enact strategies to streamline how you run your inventory and supply chain and adopt aggressive approaches to securing earlier payments on customer invoices. Finally, be willing to define these costs to all parties involved and make sure they are cognizant of these costs and how they impact the company’s bottom line. Granted, none of these approaches will completely do away with these costs. However, the focus is on pursuing strategic initiatives that effective reduce these costs.
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Copyright ©John Trenary 2020