Why The CFO Worries About Inventory

inventory optimisation

As supply chain practitioners, we understand the importance of having enough inventory to maintain supply chain flows and service levels. However, as your CFO will highlight to you – understanding the importance of inventory as it contributes towards the corporate financials as well, is the real challenge we face.

Your CFO is seeking to reduce inventory reported on the corporate balance sheets, appearing under current assets and consolidated in the total assets of a company.

This is typically achieved by deploying inventory optimisation solutions that allow firms to model their entire network, and the demand and supply at each node along the network with the targeted service levels for all flows. Accurate demand forecasting capability forms the foundation of an effective inventory optimisation function.

Reducing inventory in turn reduces the current assets of a firm. A drop in 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 current assets and current liabilities). This translates into a lower interest expense on borrowings that are typically used to finance working capital. Thus we can see that managing inventories through an efficient supply chain can produce a myriad 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!

  1. It affects the return on assets (ROA), which measures the profitability of a firm relative to the assets it uses to generate profits. ROA is calculated as net income divided by the total assets of a firm. When inventories are reduced, the total assets of the firm are reduced, thus increasing the return on its total assets.
  2. 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.
  3. Since maintaining inventory in the supply chain costs capital, any reduction in 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 earnings before interest, taxes, depreciation and amortisation (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.
  4. 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 peers within an industry, a higher inventory turnover ratio represents strong sales and effective inventory planning and replenishment functions.

How your supply chain can help the CFO

There are several supply chain processes that affect inventory and help reduce total inventory in the supply chain while maintaining fulfilment or service levels to replenish stores.

Better demand forecasting, inventory planning, and replenishment planning processes together help reduce 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 returns on assets.

Supply chain network optimisation also helps to reduce inventory levels by optimising a network that is most efficient for replenishing regional warehouses or 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 re-evaluated 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 centres.

(This article was adapted from the original article by Vivek Sehgal, May 27, 2010)

So you can see how the efficiency and design of your supply chain network impacts on your company’s overall growth and profitability. As many leading companies have discovered, it is possible for you to make a substantial contribution to achieving the CFO’s objectives without lowering service and supply chain commitments DEPENDING on how you go about addressing the topics we have touched on above.

The reality is, however, that for a variety of reasons many companies continue to retain higher than necessary operating costs and inventory levels.

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