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Having access to liquid cash is easily one of the biggest necessities for a successful small business. Having your hands on cold, hard cash means you can put that money to good use: properly compensating your employees, upping your marketing efforts, streamlining your operations, and more. However, many small businesses make the mistake of allowing too much of their cash to get tied up in their inventory. This is a rookie mistake that can easily happen for new businesses who are still learning about their sales patterns. But no matter the age of your business, this is a bad habit you must try to break.

Here are 4 ways you can control how much working capital you put into your inventory:

1. Prioritize Your List of Orders - When making  your sales projections, don’t forget the importance of detecting the demand for each of your different products. If you have one product that produces a majority of your sales, focus on producing an efficient inventory management system for that particular product. It’s important to focus more on the items that mean the most to your business, especially given the time constraints most small business owners face. A common generality is that 80% of demand will be generated by 20% of items. Prioritize that 20% to the top of your list, always checking to make sure that inventory is in stock and reordered frequently.

2. Stay On Top of Your Orders - Part of managing inventory costs is ensuring you are timely on your orders. If you over order inventory, you will tie up your cash, severely affecting your liquidity. Over ordering is always an issue for businesses, as most fear running out of exactly what they need. That’s why thoughtful projections are essential, and not just about sales, but supplies too. Referencing your past sales and orders (especially looking at what was used and what wasn’t) is the most efficient way to do so. Don’t forget to also factor in seasonal changes and any sort of promotions you will be running. It’s these sort of details that can affect year-to-year production.

3. Have a Rock Solid Inventory Management System - The great thing about technology is that it has the power to ultimately make anything, and everything, easier. This goes for inventory management. If you aren’t running on an inventory management software, you should look into purchasing one. Although it’s tempting to use Excel, its not what is best for your business. If your using a well-known accounting software like Quickbooks or Xero, you’ll find that there are already many add-ons or integrations available for you. For example? SOS Inventory.

4. Focus On the Numbers - In order to properly understand the health of your inventory, it’s important to know which metrics you should be keeping an eye on. Here are few to keep on your list:

  • Average Inventory Turnover: This metric allows you to measure the number of times per year your inventory is turned over. You can either calculate this using Sales/Inventory or Cost of Goods Sold/Average Inventory. Compare this ratio to industry standard. A high ratio indicates strong sales or ineffective buying, while a low ratio indicates poor sales or excessive buying.
  • Average Days Inventory on Hand: If you’d like to calculate this metric over a certain period of time, you will need to divide the number of days specifically in the period by the inventory turnover formula above. This metric measures the average number of days it takes you to sell your entire inventory on hand based on the cost of goods sold. If this metric is too high, it means your buying too much inventory. Lower is better, indicating good inventory management, but if it is too low, beware. This means you aren’t carrying enough inventory which will cause you to incur inventory stock out costs.
  • Average Inventory Conversion Period: This metric allows you to see the average amount of time it takes your company to go from purchasing inventory, to selling it, to getting paid for the sale. This metric holds particular significance as it allows you to see how you manage both your inventory and your receivables. You want to aim for a short inventory conversion period, as the shorter this period is, the faster you are able to convert inventory into sales.

No matter how you are currently managing your inventory, be sure to set aside some time this new year to evaluate your processes. It’s important for you to examine the numbers and ensure the proper systems are in place, allowing your inventory management to run seamlessly. The last thing you want is your hard earned cash tied up in inventory, where it is unable to help support and grow your business.

About Meredith Wood

Meredith Wood is the Director of Community Relations at Funding Gates, an online application for small businesses that allows them to track, organize and manage their receivables all with simple clicks. An avid small business writer, Meredith’s work can be seen on Amex OPEN Forum, SCORE, the Small Business Bonfire and many other small business sites. Connect with Meredith on Twitter @FundingGates.