4 Ways Inventory Management Affects SME Financial Statements
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 expenditures 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 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.
Inventory impact on financial statements
Keeping your inventory from being too high or too low can improve your financial foresight. But what defines a 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
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 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, it is crucial for you to make an inventory footnote of your inventory valuation method. The best-known valuation 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 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 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 - 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.
Stay on top of those complicated financial statements. If you can’t manage these back-office matters, we’re here to help.
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This post was first published 27 October 2014 and edited 18 March 2022.
Edited by: Maria Katrina dela Cruz