Inventory valuation: the number that decides your profit
How stock is valued changes reported profit and tax without anything physical changing. FIFO against weighted average, what cost includes, and the write-down nobody wants to make.
Working capital is the cash trapped between paying for something and being paid for it. Businesses fail with full order books because that gap grew — and it grows fastest when sales are growing.
Working capital is current assets minus current liabilities — in practical terms, the money tied up in stock and unpaid customer invoices, less what you owe suppliers in the near term. It is the cash the business needs simply to keep operating, before any question of growth or profit.
The counterintuitive part, and the one that catches people out, is that growth consumes working capital. More sales means more stock bought and more invoices outstanding, both of which are paid for before the money arrives. A business can be profitable, growing, and unable to pay wages, and the explanation is always the same gap.
Shortening the cycle by ten days releases cash without a single extra sale, and the three levers are unequal. Collecting faster is usually the largest and quickest — the ground covered in credit control. Holding less stock is next and takes a quarter to show. Paying suppliers later is the smallest and the most expensive if overused, because supplier goodwill is worth more than the days it buys.
This is a well-advertised problem, and searching for it produces a great many offers of working capital loans, invoice finance and lines of credit. Some of those products are legitimate and appropriate — a seasonal business bridging a predictable gap, for instance. But borrowing to fund a cycle that could be shortened is expensive, and the arithmetic above tells you which situation you are in. Work out the cycle first; the answer often removes the need for the product. We do not lend and have nothing to sell you here, which is exactly why the advice is worth what it costs.
The specific trap is worth stating plainly. Doubling sales roughly doubles the working capital requirement, and that money is needed before the growth pays for itself. A business planning a large order, a new location or a step change in volume should calculate the working capital it consumes at the same time as the profit it produces — otherwise the plan is a profit forecast attached to a cash problem, which is covered from the other direction in cash flow forecast.
Ettex Sheets is where the cycle calculation belongs, since it is arithmetic you want to rerun as the inputs move; the figures come from Ettex Books, the receivables side from Ettex Invoices, and the stock side from inventory management.
Current assets minus current liabilities. More usefully, calculate the cash conversion cycle: stock days plus receivable days minus payable days, multiplied by daily cost.
Because more sales means more stock and more unpaid invoices, both funded before the money arrives. The working capital requirement rises roughly in line with sales.
Shorter than it was last quarter. Absolute figures vary enormously by trade — a supermarket runs a negative cycle, a manufacturer a long positive one — so the comparison worth making is with yourself.
Sometimes, for a predictable seasonal gap. Borrowing to fund a cycle that could be shortened by collecting faster or holding less stock is expensive; work out the cycle before buying the product.
How stock is valued changes reported profit and tax without anything physical changing. FIFO against weighted average, what cost includes, and the write-down nobody wants to make.
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