As supply chain practitioners, we appreciate the significance of inventory in maintaining the supply chain flows and the service levels. Let us review the importance of inventory towards the corporate financials. Inventory is one of the components directly reported on the corporate balance sheets. It appears under the current assets and gets consolidated in the total assets of a company. Good inventory planning practices can significantly lower the inventory in the supply chain without having adverse effect on the supply chain’s ability to fulfill demand. This is typically achieved by deploying inventory optimization solutions that allow the firms to model their entire network, and the demand and supply at each node along the network with the targeted service levels for all the flows. Good demand forecasting capability forms the foundation of an effective inventory optimization function.
Reducing inventory reduces the current assets of a firm. A drop in the current assets reduces the total asset basis that translates into higher returns on assets, and it reduces the working capital (which is the difference between the current assets and current liabilities) which means lower interest expense on borrowings that are typically used to finance the working capital. Managing inventories through an efficient supply chain can produce all kinds of interesting financial rewards, consider for example, the case of Wal-Mart. In year ending January 31, 2010, Wal-Mart reported current assets of 48.3B and current liabilities of 55.5B. Since working capital is calculated as current assets minus the current liabilities, this means that Wal-Mart has operations that produce more cash than they need to run these operations!
Inventories affect a few other financial numbers as well (see the figure above):
- It affects the return on assets (ROA). The ROA measures the profitability of a firm relative to the assets it uses to generate the profits. It is calculated as net-income divided by the total assets of a firm. When the inventories are reduced, the total assets of the firm are reduced, thus increasing the return on its total assets. This is also supported by the SCMR’s survey mentioned earlier in this appendix.
- Inventory also affects the cash-conversion cycle of a firm. Cash conversion cycle measures the time that the firm takes to convert its investments into return. Cash conversion cycle is generally measured in days as the sum of inventory days (days inventory outstanding) and days receivables (or days sales outstanding) minus days payables (or days payable outstanding). Reducing inventory reduces the days inventory outstanding - keeping the other two terms constant, any reduction in inventory will naturally result in shortening the cash conversion cycle.
- Since maintaining inventory in the supply chain costs capital, any reduction in the inventory levels reduces the need for working capital. Need for less working capital reduces the interest expenses of a firm. The interest reduction translates into higher net profit, because the interest is deducted from the earnings before interest, taxes, depreciation and amortization (EBIDTA) to calculate net profit. Lower working capital requirements also lead to lower short-term debt. Lower debt levels improve a firm’s debt-ratio as well debt-to-equity-ratio.
- Reducing inventories increases inventory turnover of a firm. Inventory turnover measures the number of times the company is able to sell and replace its inventory over a period. It is calculated as cost of goods sold divided by average inventory valued at cost. When compared to the peers within an industry, a higher inventory turnover ratio represents strong sales and effective inventory planning and replenishment functions.
There are several supply chain processes that affect inventory and help reduce total inventory in the supply chain while maintaining the fulfillment or service levels to replenish the stores.
Better demand forecasting, inventory planning, and replenishment planning processes together help in reducing inventory in the system. Good demand and supply planning practices with the help of the correct tools have been shown to dramatically reduce inventories. Any reduction in inventory directly reduces the current assets and positively impacts the returns on assets.
Supply chain network optimization can also help reduce inventory levels by optimizing a network that is most efficient for replenishing the stores. This is a one-time benefit, and as the supply chain network consisting of stores, warehouses, and suppliers continues to grow, the supply network must be reevaluated to keep pace with the changes. However, frequent changes to the supply chain network are impractical due to heavy capital costs and long lead-times required to set up distribution centers.
© Vivek Sehgal, 2010, All Rights Reserved.
Want to know more about supply chain processes? How they work and what they afford? Check out my book on Enterprise Supply Chain Management at Amazon. You will find every supply chain function described in simple language that makes sense, as well as see its relationship to other functions.