Making an inventory is like having a garage sale – you check what you have and try to sell as much as you can. A definition 1 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 you as an SME. A low inventory level could delay the delivery of your goods, while an excess in stock could hinder your cash flow.
What is good inventory management, and how does it affect your business? Let’s take a look at its effects on your bookkeeping, especially in your financial statement:
It can easily determine the source of your profits and losses.
As a small business, 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 implies 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 on your financial statement indicates your chosen valuation method, which can provide you insights on your cash flow.
As you make your financial statement, it is crucial for you to make an inventory footnote of your inventory valuation method. The best-known methods are: first-in-first-out (FIFO) and last-in-first-out (LIFO). 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, however, has the reverse effect: lower gross profit, lower ending inventory, lower taxable income, and higher 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. In case you are currently using another valuation method, just attach the IRS Form 197 with its tax return, along with your financial statement.
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 goal of making an inventory is to gather all these goods and materials for selling. When sold, it increases the COGS which, in turn, is shown as considerable expense on 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 - it leads 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.
In conclusion, it is important to ensure that the inventory indicated in your financial statement is accurate. Keeping your inventory from being too high or too low can improve your financial foresight.
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