FIFO vs LIFO: What You Need to Know to Choose the Right Method

Posted on March 16, 2018 by Alla

FIFO vs LIFO? We help you decide which accounting method is best for your business.

FIFO vs LIFO: the great business accounting debate.

At the end of your fiscal year, you’ll probably use one of these two accounting methods to value your inventory and report your profitability.

But they’re distinctly different and will produce very different results on your balance sheet.

To help you understand their differences, we’ll look at the advantages and disadvantages of LIFO and FIFO and give you our opinion on which one you should use in your business.

But before we do that, let’s define FIFO and LIFO.

What are FIFO and LIFO?

To determine your cost of goods sold at the end of the fiscal year, you need to determine the cost of all the products in your inventory.

That’s where FIFO and LIFO come in. Here’s what they stand for:

What is FIFO?

FIFO (first in, first out) is an inventory accounting method that says the first items in your inventory are the first ones that leave – meaning you get rid of your oldest inventory first.

What is LIFO?

LIFO (last in, first out) is an inventory accounting method that says the last items in your inventory are the first ones that leave – meaning you get rid of the newest inventory first.

FIFO vs LIFO: Advantages and Disadvantages

FIFO and LIFO are exact opposite accounting methods that deliver dramatically different results. Before you implement either of them, you should know the primary benefits and drawbacks of each method, which we detail below.

Primary Benefits of FIFO

FIFO is the most common accounting method.
There are no GAAP or IFRS restrictions on the use of FIFO.
FIFO increases the value of your inventory during inflation because your older items with a lower cost of goods are now a smaller percentage of your sales.
There’s less record-keeping since the oldest items in your inventory are continually used up.
If costs are decreasing, you pay fewer income taxes in the near-term since the first items sold are the most expensive.

Primary Drawback of FIFO

If costs are increasing, you pay a larger amount of income taxes in the near-term since the first items sold are the least expensive.

Primary Benefit of LIFO

If costs are increasing, you pay fewer income taxes in the near-term since the last items sold are the most expensive and you report the fewest profits.

Primary Drawbacks of LIFO

If costs are decreasing, you pay a larger amount of income taxes in the near-term because the last items sold are the least expensive which lowers your cost of goods sold leading to a report of higher profits.
The IFRS doesn’t allow the use of the LIFO method.
LIFO increases your layers of record-keeping since the oldest layers could remain in your system for years.

FIFO vs LIFO: Which Should You Use?

Well, there are obviously more benefits to using FIFO than LIFO, especially in the food industry.

If you handle food inventory management or operate any business with perishable items, then you pretty much have to use FIFO. Otherwise, you’ll end up with obsolete inventory that you’ll have to write-off as a loss.

With that said, LIFO is a great method for non-perishable homogeneous goods like stone or brick. So, if you get a fresh batch of items like these, you don’t need to rearrange your warehouse or rotate batches since they’ll be the first ones out anyway.

The bottom line:

Most businesses will benefit from FIFO while a select few businesses in specific industries will be better off using LIFO.

Regardless of which method you choose, you’ll need a powerful inventory management software that can automatically calculate your cost of goods sold in real-time.

And you probably want a software that automatically tracks fluctuations in prices for POs and suppliers, and helps you get the best deal on your goods.

Where can you find an inventory management software that delivers accurate reporting and so much more?

Right here at DEAR Inventory.

Use DEAR to Make Accounting Easier with FIFO

DEAR seamlessly Integrates with top-of-the-line accounting apps like Xero and Quickbooks, it syncs all of your invoices, bills, and payments to an app that can be accessed anywhere, and is built for true cost calculations and the FIFO method of accounting. We’ll give you financial data in real-time for smarter decision-making and higher profits.

Start your free 14-day trial of DEAR Inventory today!

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Why Economic Order Quantity May Be Right (Or Wrong) for You

Posted on December 23, 2017 by

Economic Order Quantity can take the guesswork out of reordering stock, find out how.

Would you like to know exactly when you need to reorder stock and how much you need to reorder?

Then you need to calculate your economic order quantity (EOQ).

EOQ – much like a reorder point formula – helps you take the guesswork out of stocking your warehouse and keeping up with customer demand.

We’ll show you how to use an EOQ formula, it’s advantages and disadvantages, and the one tool you need to optimize your use of EOQ and any other inventory formulas.

What is Economic Order Quantity?

Economic order quantity is the lowest amount of inventory you must order to meet peak customer demand without going out of stock and without producing obsolete inventory.

That’s the ideal use of EOQ.

Its purpose is to reduce inventory as much as possible to keep the cost of inventory as low as possible.

The EOQ model assumes that demand is constant and that inventory is depleted at a predictable rate. While this isn’t the case for many businesses, the model still helps companies better approximate when they need to replenish their inventory and how much they should order.

How Do You Calculate Economic Order Quantity?

To help you calculate EOQ, here is the formula from Kenneth Boyd, author of Cost Accounting for Dummies:

Economic order quantity uses three variables: demand, relevant ordering cost, and relevant carrying cost. Use them to set up an EOQ formula:

Demand: The demand, in units, for the product for a specific time period.
Relevant ordering cost: Ordering cost per purchase order.
Relevant carrying cost: Carrying costs for one unit. Assume the unit is in stock for the time period used for demand.

Note that the ordering cost is calculated per order. The carrying costs are calculated per unit. Here’s the formula for economic order quantity:

Economic order quantity = square root of [(2 x demand x ordering costs) ÷ carrying costs]

That’s easier to visualize as a regular formula:

Q is the economic order quantity (units). D is demand (units, often annual), S is ordering cost (per purchase order), and H is carrying cost per unit.

What are the Advantages of EOQ?

Economic order quantity has been successfully used for decades by businesses of all types, so it certainly has a few advantages.

Here are some of them:

Helps Lower Inventory Costs

The primary purpose of EOQ is to help keep inventory carrying costs as low as possible.

The more inventory you have on hand, the more you have to pay for insurance, taxes, security, etc.

Accurately calculating how much inventory you need will help you maintain a budget you can afford.

Makes Restocking Easy

Economic order quantity can help you understand how often you should be ordering. You may discover that ordering small quantities more often is better for your bottom line or vice versa.

By calculating how much you need in proportion to how much you sell over a given period of time, you can ensure you always have enough stock to satisfy your customers.

Helps You Find the Best Deal

Many vendors advertise deals throughout the year to entice you to buy more of their inventory which usually ends up increasing your cost of inventory even if you received a discounted price.

The EOQ model helps you purchase only what you’re going to use.

It’ll help you take advantage of a vendor deal if, after plugging the numbers into your EOQ formula, you find out you’re not overpurchasing but getting the right amount at a lower price.

What are the Disadvantages of EOQ?

While economic order quantity has some benefits and a long history of use, it’s not without its shortcomings.

Here are a couple of them:

Requires Numerous Assumptions

The largest complaint about EOQ is that it requires numerous assumptions.

The model assumes that there’s steady demand, steady sales, and fixed costs.

Plus, the basic EOQ model assumes you have a one-product business. If you sell multiple products, you’ll have to calculate and track each one separately.

Doesn’t Account for Fluctuations During Seasons

The biggest problem with assumptions of steady demand and steady sales in the EOQ model is that it doesn’t allow you to account for fluctuations in demand during holidays or particular seasons.

If your sales yo-yo throughout the year, then EOQ won’t be able to keep up.

How to Make EOQ Work for You

Realistically, you’re unlikely (and not lucky enough) to operate a business with fixed rates and steady sales that almost never fluctuate.

If you run a business similar to the rest of ours, then you’re constantly dealing with uncertainties in your reorder point and customer demand forecasts.

EOQ can still help you make more informed guesses about when and how much inventory should be ordered, but to make EOQ calculations work properly, you’re going to need a way to monitor and track your order quantities, reorder points, safety stock levels, etc.

With the right inventory management system, you could even forget about EOQ altogether and use more up-to-date formulas that automate reordering for all of your products.

Interested in such a system?

Then we can help…

Our Inventory Management System Can Improve EOQ or Make it Irrelevant

Whether you want to use economic order quantity or not, our cloud-based inventory management system will help you streamline your business processes. From tracking your inventory in real-time to producing up-to-the-minute reports on past sales and future projections, DEAR Inventory will make sure you avoid stockouts and obsolete inventory while effectively serving your customers.

Start your free 14-day trial of DEAR Inventory today!

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VAT in UAE 2018: Answers to The Most Important Questions

Posted on December 2, 2017 by

A 5{cb377218d5687e54e8ee9149518f87201a393a7c1db5e8076e9d750029ec0dc3} value-added tax (VAT) will be effective in 2018 for the United Arab Emirates

The United Arab Emirates (UAE) Government is officially moving forward with a 5{cb377218d5687e54e8ee9149518f87201a393a7c1db5e8076e9d750029ec0dc3} value-added tax (VAT) that will take effect on January 1st, 2018 – and you need to prepare for it immediately.

Any business that’s required to register for the VAT in UAE must be registered before January 1st, 2018.

In the 3rd quarter of 2017, registration was open on a voluntary basis. Now that we’re in the 4th quarter of 2017, registration is mandatory.

If you don’t register your business before the end of the year, you’ll face penalties and fines as outlined in Section 25 of Federal Law No. 7.

To help you avoid the penalties and fees of UAE’s new tax law, we’ll answer the most pressing questions about the UAE VAT and show you exactly what it is, what it means for your business, and what you’ll need to do to remain compliant.

So let’s start with the most basic question:

What Is the UAE VAT Law and Why Is It Being Implemented?

The UAE VAT law is a general consumption tax which will apply to the majority of transactions of goods and services, including those bought from abroad. The tax will be set at 5{cb377218d5687e54e8ee9149518f87201a393a7c1db5e8076e9d750029ec0dc3} and will be implemented on January 1st, 2018.

In case you’re unfamiliar, here’s a quick overview of value-added taxes:

Value-added taxes are collected incrementally and are based on the value of the product or service at each stage of production and distribution.

So every stage of the product lifecycle will be taxed.

With a 5{cb377218d5687e54e8ee9149518f87201a393a7c1db5e8076e9d750029ec0dc3} VAT, if a supplier purchases a widget for $1 from a manufacturer, the manufacturer (the seller) will be required to charge an extra $.05 to the supplier (the buyer), and pay that $.05 to the Government.

The 5{cb377218d5687e54e8ee9149518f87201a393a7c1db5e8076e9d750029ec0dc3} tax will be added-on by every seller throughout the supply chain all the way to the final customer.

The UAE will be using this tax to curb their dependence on oil as a primary source of revenue and to provide citizens of the region with better public services such as hospitals, schools, and roads.

The UAE VAT is the second major tax being enacted after the Excise Tax took effect earlier this year.

With every new tax comes new regulations and burdens imposed on businesses covered by that tax.

Which brings us to the next question:

What will The UAE VAT Implementation Mean for Businesses?

The primary requirement for businesses in the UAE is recording all of their financial transactions and ensuring their financial records are accurate, up-to-date, and VAT compliant.

A business must register for VAT if their taxable supplies and imports exceed the mandatory registration threshold of AED 375,000 (AED is shorthand for UAE’s currency, Dirham).

However, you can voluntarily register your business for VAT if the taxable sales and imports within UAE exceed the voluntary registration threshold of AED 187,500.

Startups and small businesses can voluntarily register for VAT if their expenses exceed the voluntary registration threshold – a smart decision if they want to be eligible for tax credits.

You can register your business here. If you need help registering, the Federal Tax Authority (FTA) created this guide for you.

UAE’s Ministry of Finance clearly states that VAT-registered businesses must:

Charge VAT on taxable goods or services they supply
Keep a range of business records which will allow the government to check that they got things right
Report the amount of VAT they’ve charged and the amount of VAT they’ve paid to the government on a regular basis

The Ministry of Finance also stated that the following businesses will be charged a 0{cb377218d5687e54e8ee9149518f87201a393a7c1db5e8076e9d750029ec0dc3} VAT:

Exports of goods and services to outside the GCC
International transportation, and related supplies
Supplies of certain sea, air and land means of transportation (such as aircrafts and ships)
Certain investment grade precious metals (e.g., gold, silver, of 99{cb377218d5687e54e8ee9149518f87201a393a7c1db5e8076e9d750029ec0dc3} purity)
Newly constructed residential properties that are supplied for the first time within 3 years of their construction
Supply of certain education services, and supply of relevant goods and services
Supply of certain healthcare services, and supply of relevant goods and services

And these businesses are completely exempt from VAT:

Residential properties
Public transport
Undeveloped land
Life insurance
Certain financial services

The Ministry of Finance made it clear that businesses may reclaim any VAT they’ve paid on business-related goods or services, and may reclaim VAT if they’ve paid more VAT to the Government than they’ve charged their customers.

However, if you’ve charged more VAT than you’ve paid, you have to pay the difference to the government.

With all these responsibilities, the next obvious question is:

How Do Businesses Comply with VAT in UAE?

It should be stated that the burden of fulfilling your VAT requirements rests completely on your shoulders.

To comply with VAT in UAE, you’ll need to make the necessary changes to your financial management processes, your bookkeeping software, and your accounting staff to fulfill your role in allowing the FTA to understand your business activities and review your transactions.

Tax-paying Businesses must file VAT returns with the FTA on a regular basis (quarterly or for a shorter period, depending on the timeframe the FTA decides) within 28 days from the end of the tax period.

The most important records to keep (for a minimum of 5 years) to stay VAT compliant include the following:

Invoices

An invoice is a commercial document that records the products, quantities, and agreed prices for products or services between a buyer and seller.

As a VAT-registered business, you’ll be authorized and required to issue tax invoices in addition to normal invoices.

A VAT invoice must include the following information:

A unique sequential number
The date of issue
The supplier’s name, address and Tax Registration Number (TRN)
The customer’s name, address and Tax Registration Number (TRN)
Description of goods or services supplied
Total amount excluding VAT
Total VAT chargeable
Price and quantity of each item
Rate of discount per item
Rate of VAT charged per item – if an item is exempt or zero-rated, then mention there is no VAT on these items
Total amount including VAT

Credit Notes

A credit note is a commercial document that’s issued by a seller to a buyer when a product or service is refunded, when an invoice amount is overstated, or when a business refunds a buyer for any reason.

Debit Notes

A debit note is a commercial document issued by a buyer to a seller to request a credit note, or by a seller to a buyer to request additional payment if extra goods were delivered or goods already delivered were charged incorrectly.

What Tool Helps Businesses Stay VAT Compliant Automatically?

Staying VAT compliant is a difficult process, and it’s made worse if you’re using accounting software that isn’t designed to work with VAT.

Plus, if you’re managing your inventory and fulfilling your orders and doing your accounting in separate programs with no integration between them – you’ll increase your risk of errors and tax penalties.

That’s why we believe the most important tool you can use to stay VAT compliant is cloud-based inventory management and accounting software that does the hard work for you.

Software that has built-in advanced bookkeeping features to help ensure your accounting meets all of the UAE VAT requirements.
Software that customizes your invoices to automatically include the 5{cb377218d5687e54e8ee9149518f87201a393a7c1db5e8076e9d750029ec0dc3} VAT (and any other taxes you have to calculate).
Software that lets you keep track of sales tax across all your sales channels (from ecommerce platforms to retail stores).

And software that does all of this while tracking your inventory in real-time, fulfilling your orders automatically, and integrating seamlessly with all of your business apps.

Where will you find such a powerful software ready-made for the VAT in UAE?

Right here at DEAR Systems.

Inventory Software That Keeps You VAT Compliant with Ease

Our cloud-based inventory management system integrates with leading accounting apps such as Xero and Quickbooks for streamlined accounting that’s VAT compliant while storing all of your invoices for simplified bookkeeping. The best part is, you’ll stay VAT compliant while enhancing your inventory management at the same time.

Start your free 14-day trial of DEAR Inventory today!

Try DEAR for Free

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3 Ways Excel Inventory Management Hurts Your Business

Posted on September 9, 2017 by

Excel inventory management is good at the start but doesn’t end well.

Excel inventory management is good for one thing:

Running a small business with little growth.

If you’re just starting out or maintaining a small business without trying to expand it, then excel inventory tracking would work fine for you.

If you run a simple 1-4 person operation with little inventory and only 1-2 people inputting inventory information, an excel inventory system will give you what you need.

But if you’re trying to grow your business year after year, release new and exciting products, or expand into new markets and countries, then you’ll need a far more robust supply chain management (SCM) software.

Without a system that can handle increasingly complex orders, purchases, and stocktakes, you’re going to experience serious issues.

3 Problems with Excel Inventory Management

Error-prone

In a study of errors in 25 sample spreadsheets, Stephen Powell from the Tuck Business School at Dartmouth College found that 15 workbooks contained a total of 117 errors.

While 40{cb377218d5687e54e8ee9149518f87201a393a7c1db5e8076e9d750029ec0dc3} of those errors had little impact on the businesses studied, 7 errors caused massive losses of $4 million to $110 million, according to the researchers’ estimates.

Mistakes are easy to make, especially if you’re working with various spreadsheets and multiple people are manually inputting or copying information.

But sometimes the program itself is to blame for mistakes.

For example, a study of leading genomics journals revealed that Excel’s automatic functions were changing the names of genomes without the scientists’ knowledge.

The study revealed that one-fifth of papers with Excel gene lists contain erroneous gene name conversions.

This means Excel itself can cause errors in your reporting, and it can enhance the errors that humans naturally commit.

Lack of Real-Time Reporting

A lack of real-time inventory reports means that you are constantly behind in your inventory tracking.

Stock is being purchased and received, inventory is being sold and shipped, and your numbers haven’t been updated since yesterday.

If you think you have enough stock to cover a sudden spike in sales but find out you don’t, you lose customers.

If your assistant manager forgets a crucial part of your stocktaking process – like updating your data – and today is when you typically make purchase orders, you may order too much and run into the problem of obsolete stock or order too little and experience stockouts.

Even if you can update inventory information regularly every day, it will never be as instant or reliable as a cloud-based inventory management system.

Difficult to Scale

One of the primary reasons for keeping detailed reports is to generate accurate and useful business intelligence (BI).

To accurately forecast the future, you need to gather correct information in the present. Excel inventory management is subpar precisely because it is imprecise in organizing data due to its own flaws, and the errors caused by its users.

While Excel and Microsoft Office may offer BI tools, it requires you to learn how to use those tools and input the data without making mistakes.

According to “A Pilot Study Exploring Spreadsheet Risk in Scientific Research,” most spreadsheet errors don’t arise from mistakes in programming the spreadsheet – they arise from the misapplication of programming logic which is a result of most spreadsheet users having no formal training.

You’re an expert in what you sell, not in using Excel. Because you – like most users – aren’t an expert, you’re going to misuse or ineffectively use the program, leading to unseen errors and costly mistakes.

What’s the Alternative to an Excel Inventory System?

A program that automates the calculation of data and the generation of reports.

A system that keeps an up-to-the-minute account of your inventory.

A software that integrates with your ecommerce and accounting apps seamlessly.

In short:

DEAR inventory.

Leave Excel for the Little Guys – DEAR Is for Businesses Ready to Grow

Through barcodes and RFID technology, you’ll be able to keep your inventory up-to-date with the simple wave of a scanner. Our cloud-based inventory management system allows you to easily manage large and growing product volumes and generates real-time reports on sales, trends, and forecasts. With DEAR inventory, you’ll be able to streamline your stocktake, manage multiple locations, and ditch the outdated and error-prone method of Excel inventory management.

Start your free 14-day trial of DEAR Inventory today!

Try DEAR for Free

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Reorder Point Formula: This Is What You Need to Avoid Stockouts

Posted on August 5, 2017 by

Do you really need a reorder point formula to effectively manage your inventory?

Do you know when you’ll need to order more inventory before selling out?

Have you already experienced a few stockouts and don’t how to prevent them?

Are you relying on your “instincts” to calculate your reorder point?

You can stop being a victim to market spikes and slumps by using a proven, mathematical equation to help you consistently order the right amount of stock each month.

This equation is called a reorder point formula.

To help you improve your business processes, we’ll show you what a reorder point formula is, how to apply it effectively, and how to stop worrying about running out of stock.

By the end, you’ll be empowered with a formula that’ll help you stay on top of demands and streamline your supply chain management by accurately calculating your reorder quantity.

What is a Reorder Point Formula and How is it Calculated?

A reorder point formula tells you approximately when you should order more stock – when you’ve reached the lowest amount of inventory you can sustain before you need more.

Here’s the reorder point formula you can use today:

(Average Daily Unit Sales x Average Lead Time in Days) + Safety Stock = Reorder Point

To make this as easy as possible for you, we’ll show you how to calculate your average unit sales and lead time.

You will need to know your safety stock to make this formula work, but instead of going over that in this post, you can discover how to calculate your safety stock by visiting our post “The Power of Safety Stock Inventory and How to Calculate It.”

For the other two calculations, let’s start with daily unit sales.

How to Calculate Average Daily Unit Sales

Your average daily unit sales is the number of units you sell of a particular item over a specified period of time.

To take that out of the abstract, let’s use an example for the rest of this post to make it easy to understand.

Suppose you sell staplers.

To calculate your average daily unit sales, you would divide how many units of staplers you sold over a specified period of time.

If you sold 100 staplers over 30 days, you would divide 100 by 30.

100 divided by 30 = 3.33

So, your average daily unit sales is 3.33.

Let’s continue this example into average lead time.

How to Calculate Average Delivery Lead Time

The lead time is the amount of time it takes to receive a shipment of stock.

To get the average delivery lead time, you divide your total number of lead times by a set period of time, like 6 months.

In our stapler example, if you place an order every month, your lead time probably varies month-to-month and may look something like this:

January	8 Days
February	11 Days
March	9 Days
April	6 Days
May	7 Days
June	5 Days

Here’s how you calculate your average lead time:

Add up all the days (8+11+9+6+7+5) = 46.

Divide the total (46) by the number of orders placed, which is 6 because orders were placed once a month over 6 months.

46 divided by 6 = 7.67

7.67 is your daily average lead time.

Now that you have your average lead time and unit sales, you need to calculate your safety stock.

Again, we won’t go over that here, but you can easily calculate it using our formula in our other post on safety stock inventory.

For our purposes, let’s assume your safety stock is 20 staplers. Now, we’re ready to use our reorder point formula.

How to Calculate the Reorder Point Formula

Now that we’ve got all the numbers we need for our Stapler company example, we’re ready to plug everything into our reorder point formula.

Remember, the formula is:

(Average Daily Unit Sales x Average Lead Time in Days) + Safety Stock = Reorder Point

So, for our stapler example it would look like this:

(3.33 x 7.67) + 20 = 45.54

There you have it.

In our example, once your inventory gets down to 45 or 46 staplers, you should place an order for more.

This is a simple reorder point formula that you can use for each of your products. There are certainly more in-depth formulas you can use like this one, but the formula we’ve provided should be sufficient for most businesses.

However, just knowing the reorder point formula isn’t enough to streamline your business processes…

Here’s What You Need Next

To streamline your business, you’ll need to improve your rate of inventory turnover, upgrade your SCM software, and accelerate your stocktaking process.

But to make these processes and the reorder point formula work properly, you’ll need some way to track your orders, sales, and inventory levels

An Excel spreadsheet or pen and paper are error-prone methods that are dangerous and costly, especially when your business depends on correct and highly specific data.

If you want to manage your inventory with ease, receive real-time reports, and streamline your supply chain management, then you need to invest in cloud-based inventory management.

Use Inventory Management Software to Optimize Your Reorder Point Formula

Our cloud-based inventory management software will track every item from your supplier to your warehouse and on to your customer. You’ll know exactly how much inventory you have and how much you need, and can check those numbers any time of day, from anywhere in the world. We automate your processes and integrate our software with all your other business systems, ensuring your reorder point formula has the precise data it requires to work properly.

Start your free 14-day trial of DEAR Inventory today!

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What is Working Capital and Why Does it Matter?

Posted on June 17, 2017 by Alla

Find the right level of working capital to grow a healthy business

Working Capital is an important financial metric for understanding your company’s operating liquidity (the ability to convert your assets into cash for the purpose of paying the bills). Knowing your amount of working capital can also guide your inventory strategies, leading to smarter buying decisions.

By the book, the definition of working capital is:

Working Capital = Current Assets – Current Liabilities

In other words, it’s the cash you have left over once all payments due to you are collected and your bills are paid.

If your company maintains an inventory of goods that you sell to your customers, the formula can be expanded to:

Inventory Value (value of items for sale and items used to make goods for sale)

+ Receivables from Customers (cash owed to company for sales)

+ Rebates from Suppliers (Discounts for buying a certain value, quantity, or within a certain timeframe)

– Payables to Suppliers (cost of inventory)

= Working Capital.

What’s considered a healthy working capital varies from industry to industry – but in theory it should be as low as possible.

A low working capital is a strong indicator that your company is finding the right balance between what you have on your shelves, the revenue you are generating, the investments you are making in your future, and the debts you owe.

A high working capital can be a sign your business is booming, but it can also mean you’re missing investment and growth opportunities.

Another Insightful Approach

In the business world, working capital is usually measured not by the cash figure of assets minus liabilaties, but by what’s known as your current ratio, which is:

Current Ratio = Current Assets / Current Liabilities

According to Investopedia, your business should aim for a current ratio between 2.0 to 1.2, but this varies by industry; here are some average current ratios for industries you’re likely in, according to CSIMarket:

Internet, Mail Order, & Online Shops: 1.12
Wholesale: 1.29
Food Processing: 1.26
Miscellaneous Manufacturing: 1.55

A ratio higher than 2 is a sign that you’re not properly using your funds – either in the form of carrying too much inventory or not capitalizing on extra cash by investing in growing your business, while a ratio lower than 2 may make it difficult to find the cash you’ll need to pay your suppliers and other debts.

The metric changes as quickly as you make sales, pay suppliers, or increase your inventory – but by understanding how the decisions you make affect it, you can take control of your working capital instead of letting it control you.

Here are some aspects of your operations to consider as you create your working capital management strategy:

Turn Down Supplier Discounts

Just say no (sometimes)! Avoid the temptation to take advantage of supplier discounts when they mean ordering more inventory than you need right now.

Sure, you could buy three times the materials to reduce your per item cost by 75{cb377218d5687e54e8ee9149518f87201a393a7c1db5e8076e9d750029ec0dc3}. But unless you can actually sell that inventory, you risk filling your shelves with stuff that can quickly become obsolete, broken, or buried.

By collecting data to understand your what your customers want and when, you can better decide when it’s the right time to take advantage of these discounts.

Achieve Negative Working Capital

There are two ways to look at negative working capital – one way is a signal of financial distress for a company indicating you have spent more money than you have.

A more positive definition involves a strategy that requires careful thought and planning.

By setting terms of payment with your suppliers that give you enough time to collect from your customers before you pay for the raw materials of the items you sold – you are in essence borrowing cash from your suppliers to free up more money for your day to day operations.

This strategy requires an in-depth understanding of your customer demand cycles to ensure its possible to sell all your inventory and collect from your customers prior to your invoice due dates.

Negotiate your payment terms with your own billing cycle in mind. Be sure to give yourself an overlap period where you have cash payments in the bank, but no invoices due for the products and materials you just sold.

For example, let’s say you made $100 in sales for product X and have collected all payments due from your customers.

You owe your suppliers $50 for the raw goods you used to make product X, but the invoice isn’t due for another two weeks.

Because working capital only factors in supplier payments that are currently due, your working capital is a $100 ahead instead of only $50 – which is what it would be if you had to pay your supplier at the same time you collected payment.

Maintaining a negative working capital balance frees up cash to take advantage of opportunities to spend money on growing your business and reducing debts.

Control Inventory Levels

Inventory reduction plays a major role in achieving an ideal working capital – the less inventory on hand, the less you owe to suppliers, tipping your working capital in your favor.

Take control of your inventory levels by putting your sales and purchasing history data to work helping you predict the optimal levels of inventory necessary to operate.

The goal is to use that data to find the right balance between demand, production, and ordering raw materials or stock.

Order too much and you’ve tied up cash resources in product or materials that aren’t making you money. Purchase too little and now you run the risk of losing sales to your competitors who do have the product available for sale.

If this all seems like an elaborate guessing game, you’re not alone. Learn more about inventory reduction in our earlier post. From “lead times” to “just-in-time,” it covers the basics you need to know to get started.

Find the Balance, Achieve Results

Businesses of any size can find a healthy balance of inventory, taking advantage of supplier discounts, and payment cycles by leveraging inventory management software thanks to cloud-based tools like DEAR Inventory.

Want Better Data to Make Better Decisions?

Experience the tracking and reporting power of modern cloud-based inventory management software by starting your free 14-day trial of DEAR Inventory today!

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