Any business that stocks product, should keep a close eye on inventory
By Andrew Lisa
For David Riley, founding partner at business-improvement firm Gemini Effect, inventory management would be a piece of cake — if reality didn’t keep getting in the way.
“If you had the world the way you wanted it and you could manage things perfectly, you could operate a business without ever having to invest in inventory,” Riley says. “A company could buy something like pool filters with terms from the manufacturer to pay in 30 days, sell the filters before the term was up and have the cash available to pay the manufacturer and then pocket the difference.”
If only it were that simple.
Riley knows as well as anyone that, in the real world, there’s a very fine line between having enough inventory on the shelves to compete and having enough cash on hand to survive. The ability to walk that fine line comes down to the tedious, unglamorous, yet all-important concept of inventory turn.
Convert Cash Into Stuff, Stuff Into Cash, Repeat
Inventory turnover is a ratio that represents the frequency a business sells and replaces inventory in a given period. This rate of replenishment speaks volumes. If turn is too long, sales are weak, demand is low or the business is overstocking. High turnover generally means sales are good, but it could also mean that the business is understocking, which will eventually lead to lost sales.
Either way, every business that sells physical, tangible items is forced to walk a tightrope. They must have enough inventory on hand to satisfy customer demand, but every extra item on the shelf represents money that isn’t in the bank.
“Because there are 10 different kinds of filters, I have to buy multiples of each so I can be competitive,” Riley says. “But the greater the depth and breadth of the inventory, the greater the cash equivalent I have to have in order to support that inventory.”
For Debra Tillson-Leclerc, co-owner of the Pool Doctor in Coventry, Rhode Island, the relationship between cash and stock is simple. “You don’t want to have too much on the shelf because inventory equals money,” she says.
Slow turnover also stifles growth.
“Inventory that is not being sold or turned over is a drain on a company’s revenues and profits,” says Loren Cohodes, of California-based All Seasons Pools and Spas, which has six retail stores in addition to a service arm. “When you are not turning over inventory, it’s a direct hit on your bank account. In addition, it ties up your money and prevents you from being able to bring in products that may be better sellers.”
Calculating Inventory Turn
To determine your inventory turnover ratio, divide the cost of goods sold by the average inventory. Cost of goods is more accurate than sales because sales includes markups. Average inventory is important because it accounts for seasonality, which is more important in the pool business than perhaps any other industry.
Understanding this ratio can help you make better decisions in terms of manufacturing runs, pricing, purchasing and shedding excess inventory through promotions or sales. All of this is fairly common knowledge, but what many business owners don’t consider is the impact inventory turn has on their relationship with their lenders.
“Many banks lend based on inventory levels,” Riley says. “That gives a natural incentive to show a good, healthy inventory level.”
Inflating inventory and the number of skus that are being handled, however, can come back to bite dealers the next time they need a loan.
“Unbeknownst to many business owners, the bank is using the numbers on those balance sheets and P&Ls to do their own ratio analyses, dividing one number into another number to see, from their perspective, exactly how well an owner is managing inventory,” Riley says. “If the ratio turns out to be 10, divide that by 365 days. That means you’re turning over your inventory every 36-and-a-half days. So if the banker sees a company is moving from 36-and-a-half days to 55-and-a-half days to 122 days, they get concerned about the amount of cash needed to support that inventory.”
Beware of Inventory Creep
The fluid nature of the pool business forces owners to think on their feet, work with what they have in their warehouses and make adjustments. Those adjustments, however, can fuel a silent, lurking killer of inventory turn: inventory creep.
“Say a service tech out in the field finds a pump has gone bad and just needs a small part,” Riley says. “That small part could take three to four weeks to deliver, but the tech wants to be diligent and the dealer wants him to be diligent, so he goes into the warehouse and takes just that small part out of a pump to send it into the field right away. He goes into the field, makes the repair and never quite gets around to going back into the inventory warehouse to fix the pump so it’s usable for the next sale. So it sits and eventually becomes obsolete. That’s inventory creep, and it takes place in a lot of small instances across the inventory skus.”
This dead inventory piles up and puts a drag on turn, which has a way of making lenders get stingy. “If you write down that pump with no part,” Riley says, “then the bank won’t lend money against it and so you’ll have to come up with more cash.”
‘Bite the Bullet’
As inventory creep turns sellable items into dead inventory, business owners have to make tough choices.
“We start by moving items to and from different retail locations, where they sometimes sell differently,” Cohodes says. “Next, we discount these slow movers, starting low and increasing the discount regularly to the point that it starts selling. In addition to discounts, get creative with merchandising these items; move them to popular areas in the showroom to catch the attention of customers.”
At some point, however, you just have to face reality and cut your losses. According to Riley, “Some of the best practices are those that bite the bullet and say, ‘You know what? I spent $300 on that pump, but I also recognize that it’s never going to get fixed and it’s probably worth parts on the market. I can get someone to buy it on eBay for $80, so I’m going to liquidate it and get that $80.’ ”
Taking write-downs on your inventory is a painful, but necessary discipline to live by, particularly if your bank is lending you money based on your inventory levels. But those who can remove emotion and accept the realities of dead inventory understand that something is always better than nothing.
“We run into inventory items all the time that we ask, ‘Why do we have this? It’s been sitting on the shelf for three years,’ ” Tillson-Leclerc says. “Sometimes that turns into a Craigslist item or an eBay item. If you spent A-B-C dollars on an item you can’t sell, sometimes you have to settle for getting just A-B dollars back online — or even just A dollars. At least it’s money back into the business. It’s all about cash — turning inventory back into useable money.”
This is especially true in an industry that is at the mercy of the seasons.
“Us being in the Northeast, cash is king,” Tillson-Leclerc says. “In the winter months when swimming pools are pretty much closed and not opened again until May, you don’t want to be sitting on inventory. Inventory doesn’t pay the water bill, it doesn’t pay the electric bill and it doesn’t pay property taxes or any of the other expenses that continue all winter long.”
For Cohodes, managing inventory in a seasonal business is all about anticipation and adaptation.
“We slowly decrease our inventory as the season winds down,” he says. “We spread our inventory around all of the retail locations depending on inventory movement at each location. We utilize our local distributor and do smaller, more frequent orders.”
In the end, managing inventory turn is neither glamorous nor exciting, but it’s an art that all healthy businesses have found a way to master. “It’s not an area that owners spend a lot of time focusing on and managing,” Riley says. “Inventory is almost a necessary evil that really has the ability to chew up cash. It’s worth putting the time and energy into managing that critical asset.”
Take advantage of early buys, but don’t bite off more than you can chew
Manufacturers offer early buys because they, too, want to clean up their balance sheets at the end of the year, generate more revenue and deplete their inventory. Dealers should take advantage of deep discounts on bulk inventory in the winter months — but only if they’re sure they’ll have the cash to settle the tab when the bill comes due in the summer, Riley says. Otherwise, “they might wind up having to pay late fees, take out loans and ultimately spend more in the long run than they would have if they bought the same product on an as-needed basis,” he says.
Reclassify showroom inventory Banks want to see that a company is turning its assets over, but showroom stock is always there and could appear to be stagnant inventory to a banker who doesn’t understand the industry. “Have a conversation with your CPA and suggest moving the 15 tubs or whatever is on your showroom floor from inventory on the balance sheet down to furniture and fixtures, which is a longer-term asset that banks don’t expect to be turned over,” Riley says.
Run inventory ratios monthly, not yearly
According to Riley, most lenders run inventory ratios monthly, but small-business owners tend to examine inventory turn only on an annual basis. Pool pros would be wise, Riley says, to manage and calculate turnover on a monthly basis, just like the banks.
Give inventory managers the same incentives as salespeople “Staff in charge of this particular area should be incentivized on how well they manage inventory turn to keep it under a certain number,” Riley says. “If they can take an 87-day turn and make it a 45-day turn, they should get a quarterly bonus or some sort of recognition that this is an important part of the business.”