I love Under Armour. I am very brand loyal and it is not uncommon to see me in multiple Under Armour outfits throughout the week. As I coach both of my boy’s flag football teams, I do so decked out in Under Armour gear. However, I also know that as a company, Under Armour has had struggles in recent years.
When Under Armour reported their 2nd quarter earnings in 2018 they had good news for investors…revenues had increased by 8%. However, their CFO David Bergman spent much of his call with analysts instead talking about inventory levels. During the most recent quarter, their inventory balance grew to $1.3 billion.
The Company had a few problems as a result of its ballooning inventory balance. The first was the market was trending more towards streetwear instead of performance wear. Their days in inventory had grown to be 140. In English, this meant that it took 140 days to sell all of their inventory. It is hard to adjust to current trends when it takes 4+ months to clear our your current inventory. This also led to increasing debt levels and while the company was trying to deal with this by managing it’s payable wisely, between 2015 and 2018 the company went from having almost no debt to having over $600 million in debt.
To put Under Armour’s inventory into perspective, Nike is scary good at inventory management. While Under Armour had 140 days of inventory on hand, Nike had 90 days, meaning they managed to convert their inventory into cash faster. In fact, Nike’s overall management of inventory, payables, and receivables was so much better that their debt to equity levels was half of Under Armour’s.
Luckily for Under Armour and their investors, management was not aloof to the issue. By the end of the year, the Company was taking steps to drastically reduce their inventory levels. This would lead to an increase in cash flow and the ability to allow the company to catch up with market trends.
However, poor inventory management would continue to show up in other ways. For instance, Nike’s net margin was almost 6 times greater than Under Armour. While Under Armour was busy heavily discounting inventory just to move it faster, Nike’s inventory management allowed them to stay more current with the trends and commanding higher prices. Nike’s return on investor capital over as of May 30, 2019, was therefore 15x higher than Under Armour’s.
As a small business owner, you might look at the story of Under Armour and wonder how this relates to your small business. I can’t tell you how many small businesses I have walked into amazed at the amount of inventory they are carrying. When I ask the owner how fast they are turning their inventory, they look at me cross-eyed. When I ask how they know how much to order and when to order it, the answer often comes down to they “just know” when they need more.
These are often the same small business owners that are piecing things together a few times a year to meet payroll or pay vendors. While they wonder where all of their cash is, I know where it is. It is sitting on their shelves. An alarming number of business owners carry way too much inventory and have no system for identifying when to order more or how much to order.
Inventory management could be a college course (it actually is). There is no way to go through all of the nuances and strategies that encompass managing your inventory in a short article. However, below are three considerations that any small business owner should keep in mind while managing their inventory.
How Many Times is Your Inventory Turning?
As an accountant at heart, I can really geek out to ratios like inventory turnover. To begin, let’s start with a definition of what inventory turnover is. Inventory turnover is a ratio showing how many times a company has sold and replaced inventory during a given period. In order to calculate the inventory turnover ratio, you divided the cost of goods sold during the period by the average inventory balance.
Now it’s time to really geek out…..the next step is to determine your day’s sales in inventory. This formula will tell you the exact same thing, just in a different way. To figure out days sales in inventory, simply divide 365 days by your inventory turnover number.
Let’s go through a quick example…..
Shoes Plus has a total cost of goods sold for 2018 of $200,000. Their inventory balance on January 1, 2018 was $35,000 and on December 31, 2018, it was $45,000. The average inventory balance was $40,000. Therefore, inventory turnover would be 5 ($200,000 / $40,000). Their day’s sales in inventory would be 73 days (365 days / 5).
This would tell us that it would take Shoes Plus, on average, 73 days to sell their inventory. If, as of December 31, 2018, they never purchased more inventory, they would run out of inventory in 73 days or approximately March 14th of the following year.
The next question is, “Is that good?”. Here is why I get paid the big bucks….I don’t know. The answer depends on a lot of factors that are both unique to the business and the industry they operate in. I can tell you as of December 31, 2012 Payless Shoes turned their inventory on average 4.5 times a year and had 82 days of inventory on hand. One way for even small businesses to see how they compare is to look at public companies who readily publish this data.
Just knowing these numbers and managing to them is a huge help. If Shoes Plus saw their days in inventory balloon to 100 days, they may know they need to have a sale or not order more inventory for the next 30 days. Just that bit of information alone is valuable to a small business owner.
What is a reorder point?
I won’t go into a long, fancy definition for reorder points because it is exactly what it sounds like. At what point should a small business owner order more inventory? While this might seem straight forward, the math behind it can be complicated.
A small business owner must take into account several factors when considering to re-order inventory. They must first figure out how quickly an item is selling. Going back to our example earlier, if Shoes Plus sells an army styled flip flop, they should be able to determine how often they sell it. Let’s say they sold 365 of them last year, or 1 a day.
Next, our Shoes Plus owner should know how long it will take once an order is placed for the sandal to arrive. Let’s say the sandal is delivered from South Korea and as such, it takes 45 days to arrive once ordered.
Lastly, our owner needs to know how much to order. There are several factors that go into this, for instance, do they get a discount based on the quantity they order? How often can they place an order? How much is the shipping cost to the store? How much extra should be on hand?
Let’s say that based on a number of factors, Shoes Plus decides they should have 90 pairs of this particular sandal on hand.
Based on this information, the reorder point would be 45 pairs of the sandal. Once the quantity on hand is only 45, they should reorder. It will take 45 days to get here, and at the point, upon the inventory arriving they will be down to their last sandal (yes, this is cutting close, but we could make a small adjustment for that). They will reorder a quantity of 90. That way, on the day of arrival, they will have 90 on hand, assuming all factors stay the same.
This process is both an art and a science. While there are actually entire books written on this topic alone, the basics discussed above are the bare essentials that a small business owner should have in place.
Manage Inventory in Conjunction with Payables and Receivables.
The three keys to cash flow management are payables, inventory, and receivables. All must be managed in conjunction together. I have written before on the cash conversion cycle or cash gap.
In a perfect world, a company turns inventory quickly, gets paid quickly, and pays their invoices as late as possible. This would be the cash flow dream. However, we all know that this scenario is rarely reality. In reality, each of these must be managed and while they may seem separate, they are not.
Companies that are managing their cash flow closely know that these three processes must be managed in conjunction and regularly monitored. That way, they can quickly adjust and address issues that may arise.
As I mentioned several times, inventory management is hard. If a company like Under Armour struggles at it, what chance does a small business have? Actually, quite good. A small business doesn’t have to deal with many of the internal processes that a larger company does. Using just the strategies and ratios mentioned in this article will put a small business owner far ahead of their peers. Using a professional like Krieger Analytics or another accountant can help develop a system to efficiently and effectively manage inventory. The worst system and owner can use is the “wingin it” method (also referred to as “gut feel” and “I just know” methods).
Krieger Analytics is a unique accounting practice that is looking to provide financial clarity for the business owner so they can accomplish their goals. We aren’t the typical accountant as we want to provide a high, more comprehensive level of service to you. We help you understand your past results and plan more for the future. Unlike most accountants, I am also a small business owner so I understand the issues you are dealing with. If you would like to discuss your business and see if we may be the right solution, contact us now.