Posted by Maria Katrina dela Cruz
Oct 27, 2014
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When it comes to managing your company, being able to do a proper inventory helps make sure that your daily operations don’t run into problems – that your inventory is able to handle the demand for your products or services.
However, aside from the operational efficiency that proper inventory management provides, your inventory can also affect your financial management efforts both positively and negatively.
Let’s look into how proper inventory management benefits your financial management efforts!
What is Inventory Management?
Making an inventory is like having a garage sale – you check what you have and try to sell as much as you can. After selling your items, you account for all the expenditure you made and the profit you incurred from all the purchases. This is where inventory management in accounting enters the picture.
A definition of an inventory is “an asset that is owned by a business that has the express purpose of being sold to a customer, in the form of raw materials, work in process, and finished goods.”
Managing your inventory well is beneficial to every company. A low inventory level could delay the delivery of your product or service, while an excess of stock could hinder your cash flow – negatively affecting your finances.
Read: Why Should your Company Consolidate your Financial Statements?
Effects of inventory on financial statements
Keeping your inventory from being too high or too low can improve your financial foresight. But what defines good inventory management? And how does it affect your business finances?
Let’s take a look at the relationship between inventory management and accounting, alongside its effects on your bookkeeping, particularly in your financial reports.
It can easily determine the source of profits and losses
When it comes to your operations, everything in excess can mean immediate profit loss for you. In financial statements, what you are after is seeing good numbers in your bottom line (the amount remaining after all expenses have been deducted).
Good inventory management reflects that you are able to control your supply chain, as well as your supply’s shipping, insurance, warehousing, and other services at minimal cost.
Your inventory footnote can provide you insights on your cash flow
As you make your financial statement, you must make an inventory footnote of your inventory valuation method. The best-known valuation methods are the first-in-first-out (FIFO) and last-in-first-out (LIFO) methods.
- The FIFO method can yield a higher gross profit, higher ending inventory, higher taxable income, and lower cost of goods sold (COGS).
- The LIFO method, on the other hand, has the reverse effect: lower gross profit, lower ending inventory, lower taxable income, and higher cost of goods sold (COGS).
Depending on your chosen method, having that inventory footnote will give you and the other readers of your financial statement a clear and more realistic picture of your net income and income tax payments. In a nutshell, your choice affects the number of current assets and your gross profit statements.
It is also interesting to note that small businesses prefer the LIFO method because during periods of growth, it yields lower income and income tax payments that could enhance an SME cash flow.
It can lead you to accurate valuation of assets
On financial statements, an inventory is listed as a current asset and your valuation of inventory determines the total current asset, total asset balances, and the actual inventory itself. Another inventory management advantage unfolds when you gather all these goods and materials for selling. When sold, it increases the COGS which, in turn, is shown as a considerable expense in your statement.
Inventory errors are minimized
Financial statements reflect how you run your business; thus, it is important to ensure that they are error-free. An erroneous inventory can cause a domino effect - leading to errors in the calculation of COGS, therefore affecting both gross profit and net income calculations.
Case in point: Just imagine the implications of having an incorrect figure in the first accounting period’s ending inventory being carried over to the second accounting period as the starting inventory. This can potentially snowball and even cause bigger issues ahead.
In a nutshell, it is important to ensure that the inventory indicated in your financial statement is accurate. Inventory management in accounting helps in elevating your profit margin on a specific product, translating to more cash inflow.
Read next: 3 Financial Statements Every Business Should Have
Need Help with Your Company's Financial Management?
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This post was first published on 27 October 2014 and edited 13 September 2024. Edited by: Aly Tagamolila
