Efficient management of Inventory (aka ‘Stock’) levels can free up working capital and is an important area where a manufacturing or trading business can raise capital from itself by being more operationally efficient. Note that whereas all businesses have debtors and creditors, most but not all businesses carry Inventory. This week’s article is for those that do so it won’t directly apply to many service businesses.
To help understand the detail of Inventory, it’s worth revisiting the cash conversion cycle: a manufacturing business buys raw materials which it then improves using the production process until they are ready for sale. During this time the Inventory (if correctly recorded) would move through the categories of ‘raw materials’, to ‘work in progress’ and finally ‘finished goods’. A trading business typically buys finished goods from someone else, holds these as stock and tries to sell them as quickly as possible. Either way, the core point is that as long as the firm has items that it cannot (because they are unfinished or obsolete) or has not yet sold, it has cash tied up. The idea then is to reduce inventory to an optimal level where we have enough finished product to meet market demand, enough raw materials to feed into the production process to keep the productive machine working, yet no more than we actually need because otherwise we are locking up cash flow unnecessarily.
The one situation most firms fear more than most is a ‘stock out’. This means that a customer needs an item but the firm doesn’t have any in stock and can’t supply it at that time. The immediate effect of this is that the business loses the sale and the associate profit and cash flows that go with it. The longer-term effects may mean that the customer switches to another supplier and the firm then loses that customer permanently, a move that destroys value in the firm. This is real danger that most firms will go to great lengths to avoid, so the level of stock kept for any particular item is based on demand forecasting, plus some safety margin. If you think about it, you are trying to trade-off the optimal level of working capital management vs. the potential loss of the lifetime value of a customer. The systems that are employed to forecast optimal stock levels become very complex for large companies with many product lines.
The other core idea around Inventory management is the idea of how perishable the goods are that the firm sells. The obvious example is a fresh-produce supplier: crops must be picked, sorted, packed and shipped to their markets very quickly. Crops that sit on the shelves too long literally wilt or rot away and their value becomes negative (there are clean-up and other costs related to expired stock). A less obvious example is a hotel or Bed and Breakfast: here each bed-night that isn’t sold can never be sold again – in other words the stock expires daily and is perfectly perishable. Seats on a plane or bus expire similarly with each trip where they are unsold.
Inventory is crucial to examine in detail when buying (or investing in) a business: a detailed look at inventory can paint a clear picture of which product lines are selling and which aren’t. If you find inventory that is not selling (typically picked up by an age-analysis of each product line, or inventory item) then you’ll want to explore whether the sales forecasts for those products are reasonable. You may even get to the point where you exclude any anticipated revenue from them from your cash flows and bring the valuation of the business down accordingly. For this reason you’d normally want to appoint a qualified valuation professional who has experience in that particular industry to work out the market (as opposed to book) value of the stock. Note too that stock is not always included in the purchase price for a business, so this gives some wiggle-room when negotiation.
So how much cash can we free up from inventory management? The answer is that it depends on the industry as different types of businesses have different patterns of inventory holding, so you’ll need to know how you’re doing relative to your peers and benchmarking is very important. The metric to use is how many inventory turns your business does each year. The formula is simple: sales/inventory (typically measured using annual numbers).
Using the demonstration business on ValuationUp.com, we can illustrate how a business can free up cash and increase its valuation by improving its inventory turnover. We’ll call the starting point ‘Old Sloppy’ with Inventory of 4,200 and annual sales of 30,000 which gives an inventory turnover of 7.14x per year. This is way lower than the industry benchmark (75th percentile for the Specialist Machine fitting industry) of 206x per year that suggests some serious problems in the business (and a large potential improvement to be made). The ‘Tight Ship’ scenario shows how improving inventory turnover to 25x per year frees up cash and increases valuation:
|Inventory turnover||Free Cash Flow Y1||DCF valuation|
What lessons can we learn from how big companies manage this? Vehicle manufacturers like VW use sophisticated electronic systems to predict the optimal level of stock in each dealership based on historical and predicted sales, plus the predicated ages of each of the used-cars serviced by each dealership and the related spares they expect to be needed. They also design the floor plans of their cars to be shared across different models, for example the Golf and the Audi 3 share many similar components that not only cut down on design and manufacturing costs, but also allow for lower stock holdings across the group. This frees up cash and lets them do more with their balance sheet.
For the smaller business, the first step is measuring and reporting on your inventory turnover each month, then doing so by product line. Any old inventory should be written off or disposed of. Then as your business grows you need to put in some simple systems to help manage your inventory. Remember that if you’re buying a business a close look at its inventory levels will tell you a lot more about the business than you can expect from the seller