Retail Inventory Levels and Cash Flow
"I'm starting to feel better about my business so I'd like to start adding to my inventory pretty soon."
Earlier this week I was speaking with an independent retailer about his business. Like many independent retailers, he'd gone through an extended stretch where the only way to make a sale was to deeply discount everything. As time went along, he hadn't had the cash flow to fully replenish his inventory and had to let his inventory drop to levels he hadn't experienced before.
Since the first of the year, however, he'd seen his sales stabilize and begin to turn around. His discounting during winter clearance was much less than the year before. Still, cash flow was a concern. But as soon as he was able, he wanted to begin to rebuild his stock levels.
Makes sense, right?
Not to my way of thinking. With so many independent retailers still focusing on cash flow, rebuilding inventories might seem desirable but not realistic just yet. But I don't think it's even desirable.
Here's why. My experience has taught me all too clearly that as inventories increase, cash flow suffers. This may seem counter-intuitive to those who believe that sales will go up if they have more inventory, so let me explain.
The obvious explanation is that additional inventory has to be paid for somehow, and that will impact cash flow negatively. But it goes beyond that. If the last few months have taught us anything, as sales have begun to bounce back, it's that we didn't really need all of the inventory we used to have, that we really could have turned our inventory much more quickly, perhaps as quickly as we're turning now!
So what was all that extra inventory actually doing for us? Costing us money! Start with the carrying cost of retail inventory, which has been estimated to be anywhere from 15% to 25% of the average inventory at cost value. That's the cost of financing it, processing it, and handling it. Some of those costs may be easy to get at, like financing costs, but much of it is not so easy to isolate, as it's often buried in payroll.
But the biggest cost is the markdown expense that the entire inventory is subject to (not just the excess inventory). Heavy inventories invariably lead to earlier and deeper markdowns. Heavy inventories have a corrosive effect on full price sales. Customers sense that they don't have to make an immediate decision, that they can come back later, and maybe it will be marked down then. Full price sales get traded for markdown sales. And all those markdowns lead to dramatic erosion in gross margins.
Eroded gross margins have a devastating effect on cash flow. Each sale generates less gross margin, both in dollar and percentage terms. Eroded gross margins represent lost cash flow that would otherwise flow directly to the bottom line. The link is pretty straight forward: heavy inventories leads to increased markdowns leads to eroded gross margins leads to declining cash flow.
So my advice to the independent retailer I was speaking with was to resist the urge to increase inventory levels. Continue to manage inventories closely, with more frequent replenishment to stay on top of sales, continue to turn the merchandise quickly, rebuild a sense of urgency in his customers, and rebuild gross margins to healthy, sustainable levels.
It's an important message. Manage inventory levels closely, and you'll make more money.