Small Business Thoughts

In today’s competitive business landscape, strategic planning is crucial for companies to stay ahead. One key aspect of strategic planning that often goes overlooked is managing inventory and receivable financing costs. These costs can have a significant impact on a company’s bottom line, and understanding how to effectively reduce them can lead to improved financial performance, especially in challenging economic conditions.

When a company looks at its financing costs of inventory, it is essentially concerned with its daily cost of money. Even after the product has been invoiced, the company continues to bear this daily cost of money for every day its receivables go unpaid. In fact, some companies only consider a sale as finalized once the invoice has been paid. But how do these financing costs really affect a company’s financials, and more importantly, how can a company reduce its inventory and receivable financing costs?

To answer these questions, it’s essential to understand the concept of financing costs in the context of inventory and receivables. The first step is to determine the company’s daily cost of money and its impact on financing inventory and receivables. The company pays a daily interest rate for every day it holds inventory without selling it and covers the daily rate for every day its customers’ invoices go unpaid.

Let’s illustrate this with an example. Consider a company that finances its inventory and receivables with a yearly interest rate of 9%. The first step is to determine the daily interest rate, which is 9% divided by 365 days in a year, resulting in 0.0247%. The second step is to multiply this daily rate by the product’s cost of goods sold (COGS), which gives us the cost of money for holding the inventory for one day. For instance, if the COGS for a product is $100, the daily cost of money for holding that inventory is $0.0247 multiplied by $100, which is $2.47. Finally, the company multiplies its daily cost of money by the number of days the inventory is held before it’s sold. For example, if the company holds the inventory for 90 days before selling it, the total financing cost for that inventory becomes $2.47 multiplied by 90, which is $222.30.

The same calculation can be applied to the company’s receivables. If the company’s customers take, on average, 45 days to pay their invoices, the financing cost for those receivables would be the daily cost of money ($0.0247) multiplied by the COGS of the products invoiced, multiplied by 45 days. Continuing with the previous example, if the COGS for the invoiced products is $100, the financing cost for the receivables would be $0.0247 multiplied by $100, multiplied by 45, which is $111.15. So, in this case, holding the product for 90 days before selling it and waiting an additional 45 days for payment means that the company’s total cost to support the transaction was $222.30 for inventory and $111.15 for receivables, totaling $333.45.

These calculations clearly demonstrate the significant impact that financing costs can have on a company’s financials. Therefore, finding effective ways to reduce these costs should be a priority for companies looking to thrive in today’s economic conditions.

Now, reducing inventory and receivable financing costs may seem like a daunting task, but it’s not impossible. By understanding the daily cost of money and its implications on the company’s costs, companies can implement best business practices to minimize these costs. Here are some strategic planning initiatives that companies can pursue:

1. Aggressively Sell Slow Moving Inventory: One of the most effective ways to reduce inventory financing costs is to aggressively sell slow-moving inventory. Slow-moving inventory ties up valuable capital and incurs financing costs for the duration it remains in the warehouse. By identifying slow-moving inventory and implementing strategies to sell it quickly, companies can reduce the financing costs associated with holding onto stagnant inventory. This can be achieved through various tactics such as offering promotions, discounts, or bundling slow-moving products with popular items to incentivize customers to purchase them. Additionally, having a robust sales and marketing strategy in place can help accelerate the turnover of slow-moving inventory and minimize financing costs.
2. Optimize Supply Chain and Inventory Management: Efficient supply chain and inventory management practices can significantly impact financing costs. Companies can optimize their supply chain by working closely with suppliers to negotiate favorable payment terms, discounts, or consignment arrangements. This can help reduce the need for upfront payments and minimize financing costs associated with inventory. Additionally, implementing inventory management techniques such as just-in-time (JIT) inventory management or adopting technology solutions like demand forecasting, automated replenishment systems, and real-time inventory tracking can help reduce inventory holding periods and minimize financing costs.Match Inventory to Business Model: Align the supply chain strategy with customers’ order patterns, market needs, and business model. Avoid following strategies that work for other companies in different markets and define an inventory strategy that suits the company’s specific requirements.
3. Streamline Accounts Receivable Process: Improving the accounts receivable process can also have a significant impact on financing costs. Companies can streamline their accounts receivable process by implementing efficient invoicing and collection procedures. This includes setting clear payment terms, sending timely and accurate invoices, and following up on overdue payments promptly. Implementing technology solutions like electronic invoicing and online payment portals can also expedite the collection process and reduce the time it takes to receive payments, thus minimizing the financing costs associated with receivables.Pursue Prompt Payment, Prepayment, and Invoice Discounts: Prioritize strategies that speed up payment of receivables, such as offering discounts or price reductions to customers who make prompt payments or prepayments. This can help reduce the time it takes to collect receivables and minimize financing costs.
4. Negotiate Favorable Financing Terms with Lenders: Companies can also reduce their financing costs by negotiating favorable terms with lenders. This includes negotiating lower interest rates, longer repayment periods, or flexible payment terms. Building strong relationships with lenders and maintaining a good credit score can also provide leverage for negotiating favorable financing terms. It’s essential to regularly review and renegotiate financing arrangements to ensure that the company is getting the best possible terms and minimizing financing costs.
5. Optimize Cash Flow Management: Efficient cash flow management is crucial to reduce financing costs. Companies can optimize cash flow by closely monitoring and managing their cash inflows and outflows. This includes implementing cash flow forecasting, actively managing working capital, negotiating favorable payment terms with suppliers, and optimizing the timing of payments to suppliers and creditors. By effectively managing cash flow, companies can minimize the need for costly financing to cover shortfalls and reduce financing costs.
6. Continuously Monitor and Review Financing Costs: Lastly, it’s important to continuously monitor and review financing costs to identify areas of improvement. Companies should regularly review their financing arrangements, interest rates, payment terms, and other related costs to identify opportunities for optimization. This includes working with financial advisors or consultants to assess financing costs and explore alternative financing options. By continuously monitoring and reviewing financing costs, companies can identify cost-saving opportunities and implement strategies to reduce financing costs.

Managing inventory and receivable financing costs is a critical aspect of strategic planning for businesses. By understanding the daily cost of money and its impact on financing costs, companies can implement effective strategies to reduce these costs and improve their financial performance. This includes aggressively selling slow-moving inventory, optimizing supply chain and inventory management, streamlining accounts receivable process, negotiating favorable financing terms with lenders, optimizing cash flow management, and continuously monitoring and reviewing financing costs. By taking a strategic and proactive approach to managing these costs, businesses can position themselves to thrive in today’s economic conditions and achieve sustainable financial success.

Be sure to sign up for our weekly blog on small business thoughts where we discuss topics related to marketing/sales, planning, business financial understanding, and Human Resources.

Copyright ©John Trenary 2023. All rights reserved.