As we have described in several other texts of this blog, raising working capital reduces the profitability of the company. This maximum is also valid for inventories, which belong to the group of current assets. Inventory management is one of the most challenging areas of the administration, its failure can even make the company unfeasible.
In this article, we will better explain the relationship between working capital and inventories. We will also give you tips on how to better manage these two primary factors in corporate finance.
How does working capital relate to stocks?
As is well known, working capital is the volume of resources required to run the company in the short term. It serves to pay operational bills as well as to purchase inputs. In trading companies, most of the working capital goes into stocks.
Obviously there are companies that sell to order and work without stocks, but the vast majority make their use regularly. Inventories are therefore part of the working capital of the company, represented in the form of commodities. The higher the inventory, the greater the working capital needed to maintain it.
It should be remembered that in addition to the acquisition cost, the inventories also generate costs for maintenance, transportation, etc. All of this raises the company’s working capital needs. In this way, every time we talk about inventory increases, we also talk about an increase in working capital.
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Problems related to inventory management
Having stocks in and of itself is not a problem, the big question is the cost generated by maintaining these. It is always good to go to a store and find there the exact product that we are looking for. When we do this, we hardly think of the cost that the company has just to leave the product waiting for us. The product stopped in the warehouse or the gondola, does not generate any revenue for the company, only maintenance costs.
On the other hand, if the company does not keep stocks, no one will buy from their stores. Imagine the case where you go to a shoe store and there do not find shoes to try, but just pictures of them? Certainly you will not return to such a shop. Hence a trade-off between the increase of inventories and the growth of the operational cost of the firm.
Managers need to be efficient in their sales forecasts, otherwise turning inventory can take many months. If this occurs, the need for working capital will grow similarly, reducing cash flow and raising financial expenses.
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How to reconcile working capital management with the need for inventory formation?
To reconcile the need for inventory formation with the increase in working capital, managers need to be accountable. The first step is to calculate the SME (average storage time). Through this index, the manager can correctly dimension the ideal amount of capital to be allocated to inventories. Another calculation that must be done is the average cost of storage.
Once the average stocking term is understood, the minimum stock size of the firm should be estimated. The cost of capital tied to inventories should be less than the cost of stocking the goods. Only then will the working capital employed be properly remunerated.
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How to calculate the average storage time?
The average stocking term (PME) is obtained by dividing the average stock of the year by the cost of merchandise sold. The formula for your calculation is as follows:
PME = Medium stock CMV x 360
Imagine that a company has maintained an average stock of $ 100,000 over the year. If the cost of merchandise in the DRE was R $ 1 million, the SME will be 36 days (1.2 months).
This is the term in days, which the average of the goods takes to be acquired in the stores of the company. If the company obtains short-term capital to finance inventories, the maturity must be 36 days + PMR (average term of receipt).
Imagine that this company sells on time and receive with 30 days. Its total term is 36 + 30. Thus, the minimum term for payment of working capital loans should be 66 days. If she is able to pay her purchases in the long term, say 20 days, her loan may have 36 + 30 – 20 = 46 days due.
How to calculate the amount of working capital needed to maintain inventories?
The working capital required to maintain inventories will be equal to the value of the PMP multiplied by the average stock. In the case of the company in this example, it would be R $ 100 thousand X 36 / 1.2 = R $ 120 thousand. That is, the company will need to keep R $ 120 thousand in its inventory to maintain the current level of sales.
If the company can sell its stocks faster, the PMP will fall and consequently its cost as well.
Is there an ideal numerical ratio of Working Capital X Stocks?
There is no universal ideal relation between working capital X stocks. But, each company can build their relationship in a personalized way by answering the following questions:
- How much does increasing inventory make revenue grow?
- What is the financial cost for each $ 1 added to the stock?
- What is the reduction in profitability caused by the increase in working capital applied to each R $ 1 in inventories?
Once these questions have been answered, managers can create scenarios and cross data. The optimal value of working capital and inventories will be the one that maximizes the profitability of the company.
All trading companies should be concerned with inventory management. This statement is not new to entrepreneurs, however, many of them do not consider inventories as part of working capital. The understanding that inventories are part of working capital, ends up revolutionizing the way in which its management is carried out. Anyway, the correct thing is that the stocks are financed by capital of cost inferior to the one of its acquisition and maintenance.