When running a small business,one might wonder, how does inventory affect cash flow? Understanding this relationship is vital for effective stock management and financial health. A few concepts can help you improve your stock management, review the cost of goods, and upgrade the cash flow.
How does inventory affect cash flow?
There are two primary cash flows – inflows and outflows. The Cost of Goods Sold (COGS) defines the correlation between inventory and your business’s cash flow.
When you procure inventory for your business, the capital used is your business’s cash outflow. The outflow encompasses all direct costs in producing goods, including materials and labor. You receive an inflow of cash when you sell the inventory to consumers.
Understanding How Inventory Affects Cash Flow
Inventory is among the primary factors that affects your cash flow. It contributes to how much cash you spend and earn.
One of the critical oversights in inventory management is not recognizing how excess inventory can negatively affect cash flow, tying up funds that could be used elsewhere in the business.
Some businesses make the mistake of overshooting their inventory. You could dig your business into a hole in your inventory that doesn’t match the demand. Another common mistake business owners commit by treating inventory outflow as a regular expense when it isn’t.
Inventory purchases are not a regular expense
Regular expenses, such as rent, utilities, and salaries, are fixed fees. When an outflow of your cash goes according to the schedule, you identify fixed costs. Expected payouts make up a business’ regular expenses. Your inventory should not fall under this category.
Businesses don’t have to automate purchases made to increase inventory. As demand fluctuates, you cannot accurately predict how much stock you need to supply to consumers.
The outflow of cash you spend on your inventory falls under the COGS category. Your business’ COGS metric helps you define its gross profits, financial management, and overall efficiency.
There are many computations of COGS, including determining your net profits. Account for your company’s COGS thoroughly and on schedule for better accuracy.
How to calculate the cost of goods?
A key component in grasping how inventory affects cash flow is through calculating the Cost of Goods Sold (COGS). This formula can help you calculate the total cost of goods sold. Typically, business owners use:
Beginning Inventory + Purchases – Ending inventory = Cost of Goods Sold
To get all the required formula components, follow several simple steps:
- Take your initial inventory recorded at the beginning of your fiscal calendar
- Add it to the number of any additional inventory you purchased within the year
- Subtract the inventory you didn’t sell by year’s end
The difference will give you your company’s total Cost of Goods Sold. You can now use it to compute your net income with this formula:
TOTAL INCOME – TOTAL EXPENSE = NET PROFIT
Your overall profits or GROSS PROFITS generate the total income.
Total expense encompasses all six categories of cash outflow:
COGS + OPEX + D&A + Interests + TAX + SG&A
Types of expenses
To make your calculations more accurate, learn to identify different types of business expenses.
Operating expenses
They include rent, electricity, water, salaries, and everything else to keep your business running and account for your OPEX. Your OPEX makes up most of your regular expenses.
Spending that doesn’t directly generate sales creates indirect costs.
These are the costs of operating your business and don’t factor into your business revenue. Accounting for your business’ operating expenses helps you track the money flow.
Businesses that keep tabs on their OPEX are more flexible in the course of their business evolution.
Depreciation and amortization
They refer to the depreciating value of your assets like goods and finances. Amortization relates to intangible aspects such as financial assets, including loans.
Concerning your inventory, depreciation accounts for the value of your goods lessening over time, including each good or asset used in producing the goods.
Interests
Whether simple or compounded interests, these refer to amounts in percentage incurred by loans, bonds, and debts. Interests are non-operative, meaning they are not factored into your daily expenses.
Taxes
Overall, you would pay five types of taxes in running a business.
Income tax returns must be filed separately from your individual income tax return using the 1040 IRS Form. If you are the sole proprietor of your business, you must file your self-employment taxes.
Estimated taxes are filed quarterly according to your projected year-end income. Suppose your estimated taxes are lower than your annual filed income. In that case, you will incur penalties on top of their difference.
Depending on what state you do business in, you will be required to collect sales taxes by remitting them to the state.
If you have employees on your payroll, you must file employment taxes. You will withhold a certain amount of your employee’s paycheck to file these taxes. You will pay fifty percent of their dues to official institutions on their behalf.
SG&A
Aspects of your business that indirectly affect your sales and earn you revenue are considered selling, general, or administrative expenses.
Selling expenses are often mistaken as OPEX. Recruiting delivery services, like shipping and handling your products, are not included in your operating expenses.
However, shipping and delivery fall under selling, general, and administrative expenses.
Inventory and shipping
Your inventory and shipping go hand in hand. The purpose of your business’ logistics is to move your inventory. Improper stock handling can result in returns and put your reputation on the line. Reputable freight shipments can cost you more than you can afford, but you can’t always trust cheap courier services. By mastering these stock management tips and understanding how inventory affects cash flow, business owners can make informed decisions to enhance their financial stability.
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