This article will deep dive into how improper quantification of supply side risk leads to excess inventory holdings which have severe financial consequences.
Inventory is amount of goods kept in store to ensure consumer demand can be met between supply replenishment cycles.
Inventory is sum of:
a) The expected demand until the next replenishment
b) Buffer (safety) stock to account for variability in demand
The variability of the demand is modelled to determine inventory.
Forecasts are generated based on past demand, shift in consumer mindset and macro trends. This helps determine what inventory to keep of products.
The amount of inventory to keep for various products and raw materials is determined by:
a) the variability of demand of the product
b) the reliability of the supply of the raw material
Currently reliability of supply is not quantified scientifically and is not mathematically grounded given the lack of platforms, tools that can mathematically quantify the risk in the supply based on lead times, past service levels, supplier locations, logistics mode etc.
This results in emotional, and fear driven decisions on the amount of inventory to be kept. The buffer amount quantity is determined reactively based on risks that come up in real-time. Given the increased volatility of the world such decisions are increasing and lead to significant costs to the business. The overall cost of increased inventory includes the following:
1. Holding and storage costs – Costs generated due to requirement of excess storage space
2. Excess Inventory handling (transportation) costs – Costs due need of increased transportation capacity
3. Interest rate on working capital – Inventory of raw materials is brought on credit and only paid off once the finished goods are sold by the customer. Excess inventory means bearing increased interest costs. Taking longer to replay also compromises the credit score of the company with the banks resulting in increased interest rates for future credits.
4. Stuck up working capital – The excess inventory capital results in limited availability of capital for business growth such as sales and marketing. The opportunity cost of keeping excess revenue in decreased future revenue.
5. Inventory Obsolescence – A portion of inventory is not utilized due to damage, expiration, quality or lack of demand. Holding excess inventory results in excess higher inventory obsolescence.
P&L and Balance Sheet Impact
Various figures on the balance sheet and financial ratios of a company are impacted because of increased inventory. This is published in quarterly reports that directly impacts share prices and shareholders:
Inventory Turnover Ratio: Decreases, indicating slower sales or overstocking.
Current Ratio: May increase, but with potentially misleading liquidity implications due to non-liquid assets.
Quick Ratio (Acid-Test Ratio): Decreases, highlighting potential liquidity issues as it excludes inventory.
Gross Margin Ratio: Can decrease due to higher costs and possible discounted sales.
Return on Assets (ROA): Decreases, as excess inventory signifies less efficient asset utilization.
Working Capital Ratio: Increases, reflecting higher funds tied up in inventory.
Days Inventory Outstanding (DIO): Increases, indicating longer holding periods for inventory.
Return on Equity (ROE): Potentially decreases due to reduced profitability from excess inventory.
Total Asset Turnover: Decreases, showing less efficient use of assets in generating sales.
Net Profit Margin: Decreases, as excess inventory can lead to higher costs and lower sales efficiency.
Below is a sample case study for an Electronic SME manufacturer quantifying the increased costs due to due to excess inventory:
Company Operations:
Business: Manufacturer of electronic gadgets
Annual Sales (units): 100,000 units
Regular Inventory Level: 10,000 units
Increased Inventory Level: 20,000 units (due to anticipating higher demand)
Cost per Unit of Inventory: $100
Annual Holding Cost as a Percentage of Inventory Cost: 10%
Average Selling Price per Unit: $150
Company Financials:
Annual Revenue: $15,000,000 (100,000 units × $150/unit)
Total Current Assets (before increase): $5,000,000
Total Current Liabilities: $2,000,000
Total Assets: $10,000,000
Net Income: $1,200,000
Financial Impact of Increased Inventory
1. Holding Costs
Regular Holding Cost:
10,000 units×$100×10%=$100,000
Increased Holding Cost:
20,000 units×$100×10%=$200,000
Increase in Holding Costs: $200,000 - $100,000 = $100,000
2. Cash Flow Impact
Capital Tied Up Regularly: 10,000 units ×× $100/unit = $1,000,000
Capital Tied Up After Increase: 20,000 units ×$100/unit = $2,000,000
Additional Capital Tied Up: $2,000,000 - $1,000,000 = $1,000,000
3. Potential Obsolescence
Assume 5% of the excess inventory becomes obsolete.
Cost of Obsolescence: 5% of 10,000 excess units ×× $100/unit = $50,000
Summary
Cost Category | Cost Before Increase (USD) | Cost After Increase (USD) |
Holding Costs | $100,000 | $200,000 |
Capital Tied Up | $1,000,000 | $2,000,000 |
Obsolescence Costs | $0 | $50,000 |
Total Additional Costs | $100,000 | $150,000 |
Impact on Financial Ratios based on the company financials
Inventory Turnover Ratio: Decreased from 18 times to 9 times, indicating slower inventory movement.
Current Ratio: Increased from 2.5 to 3, but this may not reflect true liquidity due to excess inventory.
Quick Ratio: Remained the same at 2, indicating liquidity status excluding inventory.
Return on Assets (ROA): Decreased from 12% to approximately 9.2%, indicating lower asset efficiency due to increased inventory and associated costs.
Hence overall excess inventory results in:
· Opportunity Costs of $1,000,000 – which is stuck up capital that could have used in business growth
· Increased Costs: $150,000
· Key financial ratios impacted reflecting changes in asset management, liquidity, and overall financial performance directly impacting share value.
