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Launching a new business venture presents its fair share of challenges. You may appreciate that working capital management is vital to managing your startup’s finances. If your startup is a product-based business, this inherently requires you to keep an accurate inventory of your goods. An accurate inventory management system is essential to ensure your startup runs smoothly and that your working capital is managed effectively. This article will explain what inventory management is and how it can enhance your startup’s working capital.
What is Working Capital?
You can calculate working capital by looking at your startup’s current balance sheet. The formula is:
The most important current assets for working capital are:
- inventories;
- trade receivables (i.e., issued but unpaid invoices); and
- cash and cash receivables (i.e., all the cash your startup has in the bank account).
The two most important current liabilities are your startup’s:
- bank overdraft; and
- its trade payables (i.e., supplier invoices you have not yet paid).
What is the Purpose of Working Capital Management?
You can think of working capital as a net investment in your startup’s short-term assets, such as your inventories, cash, and trade receivables.
These current assets move in and out of your business based on its operations. Consider the following process of a manufacturing startup:
- You acquire raw materials from a supplier, which you need to manufacture your goods. As a result, you incur a liability in the form of a trade payable.
- The acquisition of raw materials is a corresponding asset on your balance sheet. Your business uses these raw materials to begin the manufacturing process.
- You transform the raw materials into works in progress and then into finished goods.
- You sell these finished goods to customers, transforming inventory assets into trade receivables.
- At the point you collect on your invoices, your trade receivables become cash. You use this cash to pay off your supplier, which supplies you with further raw materials.
- The process repeats itself.
This process again depends on the industry your startup operates within. However, it is in your startup’s best interests to create as much efficiency as possible in this process. The more efficiency within this process, the greater the likely return on investment you will see on your short-term assets.
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Why is Inventory Management So Important?
The following industries’ operations require that they maintain an inventory:
- retail and wholesale;
- manufacturing;
- distribution and logistics;
- automotive;
- electronics;
- food and beverage;
- pharmaceuticals;
- construction;
- oil & gas;
- agricultural; and
- textiles.
As you can see, any business whose operations depend on the inflow and outflow of physical goods must contend with inventory management. As a rule of thumb, for every £1 spent on inventory, you should have this available in your working capital. This is because, for every £1 you spend, you cannot allocate this amount to paying liabilities. You also cannot allocate this amount to funding other working capital expenses.
For instance, pre-purchasing raw materials in cash may give you an upfront discount on bulk purchasing. However, you lose any interest that might otherwise have accrued on the cash in your current account. Nor can you use that cash to fund other aspects of your working capital.
Alternatively, you may consider whether it would have been more cost-effective to fund the inventory purchases on supply credit. Under such circumstances, could you delay cash repayments for as long as possible while maintaining your supply relationships?
The answers depend on your specific industry and startup’s circumstances. However, inventory management has evolved, and a number of strategies exist to optimise the working capital of your startup.
Further Considerations for Inventory Management
Inventories are treated as an asset on your startup’s balance sheet because they hold financial value for your startup. However, they also create certain financial and operational liabilities.
Advantages
From a practical perspective, holding inventories gives your business the following advantages:
| Continuous production/operations | Higher inventory levels enable continuous production, mitigating disruptions or delays in the supply chain. |
| Manage supply chain disruptions | It is worth pointing out that supply chain disruptions are serious threats in their own right, as emerged following the COVID-19 pandemic. |
| Minimise effect of fluctuating demand | Another advantage is that you minimise your risk of having to pay a premium for rush deliveries to meet increased demand. |
| Bulk purchase discounting | Larger inventory quantities allow businesses to negotiate better prices with suppliers, leading to cost savings. |
| Hedge against inventory price increases | Surplus inventory acts as a buffer against price increases, allowing businesses to avoid purchasing at inflated prices. |
| Reducing lead times | Adequate inventory levels help businesses fulfil customer orders promptly, reducing lead times and enhancing customer service. |
| Minimise risk of stockout | Holding more inventory minimises the risk of stockouts. This safeguards against lost sales and protects your brand’s reputation. The customer goodwill associated with your brand is also preserved. |
Disadvantages
At the same time, surplus inventory creates certain disadvantages. These include:
| Holding Costs | Businesses incur expenses related to storing and managing inventory. These include warehouse rent, utilities, insurance, security, and inventory management systems. |
| Inventory Obsolescence | When inventory items become outdated or unsellable due to changing market trends or technology advancements, businesses may face losses due to inventory obsolescence. |
| Risk of Shrinkage and Spoilage | If inventory is held for too long and prices of the goods decline, the business may face a reduction in the inventory value on the balance sheet. |
| Opportunity Cost | The capital tied up in inventory could be used elsewhere in the business for investments or growth opportunities. Consequently, this could, in turn, reduce the company’s overall profitability. |
| Holding Costs during Price Declines | If inventory is held for too long, and prices of the goods decline, the business may face a reduction in the inventory value on the balance sheet. |
| Storage Space Constraints | Maintaining large inventory levels may require significant storage space, and limited capacity may become a constraint for expansion or new product lines. |
| Higher Financing Costs | Businesses incur expenses related to storing and managing inventory, including warehouse rent, utilities, insurance, security, and inventory management systems. |
How Do I Manage My Inventory?
Here are some general tips for managing your inventory to maximise your working capital.
| 1. Set Inventory Levels | Determine optimal inventory levels based on demand forecasts and sales patterns. Avoid excessive stock to reduce holding costs. |
| 2. Monitor Inventory | Regularly track inventory levels to avoid stockouts or excess. Use inventory management software for accurate and timely updates. |
| 3. Vendor Relations | Cultivate good relationships with suppliers to negotiate favourable terms and ensure timely restocking. |
| 4. First-In-First-Out (FIFO) | Follow the FIFO principle to sell the oldest inventory first and avoid obsolescence. |
| 5. Safety Stock | Maintain safety stock to address unexpected demand spikes or supply chain disruptions. |
| 6. Analyse Inventory Turnover | Calculate the inventory turnover ratio to assess efficiency and identify slow-moving items. |
| 7. Inventory Audits | Conduct periodic physical audits to reconcile stock on hand with records. |
| 8. Optimise Inventory Costs | Minimise storage, insurance, and obsolescence costs to enhance profitability. |
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Key Takeaways
Holding inventories efficiently offers advantages like continuous production, supply chain resilience, cost savings through bulk purchases, and better customer service. However, it also poses challenges such as holding costs, obsolescence, shrinkage, opportunity costs, and limited storage space. To optimise working capital, your startup should set appropriate inventory levels. Your startup should also regularly monitor stock levels and maintain good relationships with your vendors. It is also worth your startup employing the FIFO method to prevent goods’ obsolescence. Additionally, your startup should analyse inventory turnover to minimise inventory-related expenses. Effective inventory management ensures financial stability and streamlined operations for startup businesses.
If you need help understanding how effective inventory management can enhance your startup’s working capital, contact our experienced startup lawyers as part of our LegalVision membership. For a low monthly fee, you will have unlimited access to lawyers to answer your questions and draft and review your documents. Call us today on 0808 196 8584 or visit our membership page.
Frequently Asked Questions
Inventory management directly affects your startup’s working capital. If your startup has effective inventory management, you will have the amount of stock you need to meet customer demand while minimising associated costs.
Poor inventory management can lead to increased holding costs, stockouts, obsolescence, and reduced cash flow. This negatively impacts your startup’s profitability and customer satisfaction.
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