Last Updated: Feb 20, 2013
If your retail business’s cash flow is not what you need it to be, chances are your inventory is to blame. Here’s how to manage inventory so that cash flow doesn’t suffer.
Cash flow is the most serious issue small retailers struggle with. Whenever I get a call from a small retailer looking for help, they often are most concerned about cash flow. They may describe it in different terms — their sales are flat, margins are off, expenses are up — but in the end what they’re talking about is cash flow. This is no small matter. Without question, cash flow is the most serious issue small retailers struggle with. Where has all the cash gone?
The answer can usually be found on the Balance Sheet. Typically, most small retailers’ assets are tied up in inventory, in some cases as much as 70% to 80% of those assets. Inventory is the critical cash-generating asset of any retailer. The name of the game is turning inventory as quickly as possible at the best margins possible.
Unfortunately, inventory has a funny way of consuming any available cash. New items, new categories, broader assortments, greater depth of stock. There’s always something to buy, and (what seems like) a good reason to buy it. So, if cash is tight and you’re wondering where it’s all gone, look to your inventory.
Pareto’s Rule and Assortment Creep
It’s called Pareto’s Rule, the old 80/20 rule. In retail, it almost never fails that 80% of your sales come from 20% of your inventory. It’s the hot item, the hot category that drives your sales. The issue, however, isn’t with this portion of your inventory. The issue is with the other 80% that’s only generating 20% of your sales.
Think about it. 80% of your inventory is only generating 20% of your sales! How did that happen? The answer is something I call assortment creep. Assortment creep is the slow, steady, almost imperceptible addition of items and categories to your existing merchandise mix, which adds to SKU counts and inventory levels, but not significantly to sales, and thus drains cash from the business.
Assortment creep can occur within a category when you try to have every conceivable item, style or color a customer might want. Most small retailers live in mortal fear of a customer walking out without finding what they want. But stocking everything they might want is an extremely expensive proposition, and will likely leave your customers with more choices than they truly want or need.
It can also occur when you attempt to leverage your strength in your core categories by expanding into what you believe are related or complementary categories. It is a perfectly reasonable strategy to increase sales and grow the business. But jumping into new categories without carefully testing them first can leave you staring at a lot of cash disguised as inventory.
No small retailer can be all things to all customers. Stay focused. It is essential to maintain a clear-eyed focus on the core mission of your company, who your customers are, how they perceive you, and what they expect from you. Your assortments must reflect this focus. After all, would you rather invest your cash in inventory that contributes 80% of your sales, or inventory that only contributes 20%?
Chasing the Last Sale
Most retailers I work with tell me their goal is to maximize sales. When I reply, “No, you’re goal is to maximize cash flow,” they look at me like I have two heads. Aren’t they the same thing? No, they’re not. In fact, if you seek to maximize sales you’ll find your cash quickly evaporating. I call this chasing the last sale.
It seems instinctive to think that if you buy more you’ll sell more. The problem is that it’s impossible to know which sale will be the last sale. Will be at 90%, 100% or 120% of your sales plan? So how much inventory do you buy? If you buy enough to never run out, you’ll never run out. And when the season is over, after you’ve paid the invoices, and incurred the expenses of maintaining and merchandising that inventory, you’ll mark down whatever is left over. And the return on your inventory investment will get hammered.
The key is to guard your cash. Buy and ship inventory as close to the time of sale as possible, and always revise and update your sales forecast prior to the next purchase. Don’t chase the last sale. Only buy enough to cover your sales plan through your date of first markdown, plus a reasonable ending inventory (the amount you’ll mark down) and no more. If you should happen to exceed your sales plan, you’ll merely be eating into your ending inventory, and reducing your markdowns. And if you run out, you’ll have no markdowns. Then put out for sale the next season’s goods, that you haven’t had to pay for yet, and that you can sell at full markup.
Dead inventory is the result of failing to take markdowns on a timely basis. And without a commitment to not let dead inventory build up, it will build up, until it represents a significant percentage of your inventory, tying up cash desperately needed elsewhere in the business. In my experience, I’ve seen dead inventory represent as much as 30% of the overall inventory investment. That’s a lot of cash.
All merchandise has a life cycle during which customer demand will peak, then ebb. Whether it’s seasonal merchandise, or merchandise sensitive to fashion trends or obsolescence, once customer demand has ebbed, it takes extraordinary markdowns to spur sales. And once that happens, the market value of that inventory will likely erode by 50% or more annually.
I urge all my clients to establish a markdown budget, and to use it to assure that markdowns are being taken on a timely basis. Retail buying is, after all, all about batting averages. Not every purchase will pan out exactly as planned. Mistakes will be made. And when they are, it’s critical that markdowns be taken quickly to clear out any remaining inventory. The only thing worse than blowing through a markdown budget is not taking any markdowns at all.
Other Considerations: Capital Spending and Cash Flow from Operations
Certainly, cash flows can be impacted by excessive, unproductive capital spending. New stores that haven’t pulled their weight, additional office and distribution space that hasn’t generated the expected cost savings or improved efficiencies, or other things like new computer software packages all can be serious cash drains. But there’s a big difference between a cash crunch attributable to capital spending projects, and cash flow shortfalls from day-to-day operations. After all, if capital spending has chewed into cash, it was the cash flow from operations that was supposed to pay for it.
Which brings us to gross margins. My next column will focus in greater detail on managing your gross margins. For our purposes here, however, it’s enough to say that left unmanaged, gross margins will naturally erode over time, silently robbing you of cash. Competitive pressures that force you to accept below standard markups, vendor price increases that push your retail prices up against natural price points, unanticipated shifts in your sales mix toward lower priced and lower margin merchandise are just several factors which cause margins to erode. It is essential that you constantly challenge your merchandise assortments to generate an extra point or two in margin to offset any erosion, and protect your cash flow from operations.
Managing your merchandise, your inventory, may seem like a daunting task. It requires a focus and commitment to quantitative analysis, which can seem overwhelming to many small retailers. But those small retailers who make the commitment reap the rewards. Sales go up, inventories go down, and the constant, seemingly never-ending cash flow pressures ease. It’s not a one-time fix, but an on-going discipline. In time, cash flow becomes one of your greatest strategic assets, the engine that drives the growth of your business.