JPAbusiness managing director James Price shares a case study illustrating the cost of poor inventory management. James also provides advice on managing the other 'working capital levers' critical to business success. The eBook includes the JPAbusiness Working Capital Checklist.

1. Managing cash flow
and working capital
How to reap the rewards of good
inventory management

2. jpabusiness.com.au
+61
2
6360
0360
2
Table
of
Contents
Introduction
...........................................................................................................
3
Cash flow
..................................................................................................................................................................
4
Working capital
.....................................................................................................................................................
4
Chapter
1:
Don’t
pay
the
price
of
poor
inventory
management
..............................
5
Costly legacies
........................................................................................................................................................
6
Beauty (of stock) in the eye of the beholder
.................................................................................................
6
Too little stock also costly
....................................................................................................................................
7
A timely reminder
...................................................................................................................................................
8
How stock holdings are valued
..........................................................................................................................
8
How to ensure your stock holding maintains its value
.................................................................................
9
Don’t be tempted to sell off excess stock quickly
.........................................................................................
9
Chapter
2:
Managing
inventory
to
maximise
value
................................................
10
How much stock is too much?
..........................................................................................................................
10
How to calculate Inventory Turnover Ratio
.................................................................................................
11
Hold excess stock at your peril
.......................................................................................................................
12
Why doesn’t inventory management get the attention it deserves?
....................................................
13
Assessing your working capital position
.......................................................................................................
13
Chapter
3:
JPAbusiness
Working
Capital
Checklist
.................................................
15
Working capital checklist
.................................................................................................................................
16
Chapter
4:
How
cash
flow
and
working
capital
impact
business
value
...................
20
What we look for in the due diligence process
.........................................................................................
20
Disclaimer: The information contained in this eBook is general in nature and should not
be taken as personal, professional advice. Readers should make their own inquiries and
obtain independent advice before making any decisions or taking any action.

3. jpabusiness.com.au
+61
2
6360
0360
3
Introduction
Comments by James Price
JPAbusiness Pty Ltd
When we started our eBook series, about two years
ago, one of our first eBooks focused on cash flow.
Cash Flow Management for Small to Medium-Sized
Businesses was written post the GFC, because
we saw cash flow management as an
important success factor for our clients in
managing the dynamics of their businesses in a
challenging environment.
We recently completed the transaction on a
business sale for a client and it served as a
reminder of how important both cash flow
and working capital are to the success of a
business.
In particular, it reminded us how important they
are to building business value and therefore,
when exiting a business, receiving value from the marketplace.
The levers that impact cash flow and working capital are critical to
running a successful business day to day, but they are also critical to building
business value over time.
This eBook will address those levers, paying particular attention to the
inventory ‘lever’. A lot of money can be made or lost based on your
inventory management, as our recent experience proved.
First up though, a couple of definitions…

4. jpabusiness.com.au
+61
2
6360
0360
4
Cash flow
Cash flow refers to the amount of surplus or deficit cash a business
generates within a specified period of time.
Cash flow is almost never equal to net profit as companies tend to sell on
credit and borrow money.
Furthermore, the cash generated through sales can be reinvested in the
business or other assets, such as real estate, shares and interest-bearing
investments.
Therefore, your accountant or advisor cannot simply compare the cash at
hand at the beginning and end of the accounting period to determine cash
flow.
Instead, they prepare a special report, called the Statement of Cash Flows.
Working capital
Working capital is the difference between a business’ current assets (e.g.
debtors, inventory, etc.) and current liabilities (e.g. creditors, short-term
lines of credit, ATO and employment liabilities).
In accounting and finance, the term ‘current’ refers to assets that can be
turned into cash, or liabilities that are due in less than 12 months.
Because both figures are stated in the balance sheet of a company or firm,
the calculation of working capital is a simple task.
A large amount of working capital means the current assets of the company
are more than sufficient to cover current liabilities that are soon due.
Negative working capital means the company may not be able to pay
upcoming bills with the amount of money, soon-to-be-collectable receivables
and other assets, it holds that can be turned into cash on short notice.

5. jpabusiness.com.au
+61
2
6360
0360
5
Chapter 1: Don’t pay the price of poor
inventory management
Comments by James Price
JPAbusiness Pty Ltd
Recently we were involved in facilitating the sale of a strong, independent
business involved in import and distribution.
It was a well-known, independent brand that had been established for well
over 50 years. It had a lot of history and solid bottom-line performance.
Overall the business was successful in delivering what it promised to its
customers and had been successful in delivering value to its owner day to day.
Unfortunately, when it came time to exit the business and realise its value
in the marketplace, there were a few legacy issues that provided some
difficult negotiation challenges.

6. jpabusiness.com.au
+61
2
6360
0360
6
Costly legacies
Sometimes, many years in business delivers great benefits – and it had for
this business – but it also leaves some less positive legacies.
One of the legacies that was very clear in selling this business was the
amount of inventory (stock on hand) – it was very significant.
We negotiated a price for the goodwill, plant and equipment etc, based on a
multiple of Business Maintainable Earnings (BME), which is essentially the
cash flow of the business.
Then it was time to address the stock value.
Usually stock on hand is valued by way of a stocktake and its value is paid by
the purchaser at completion.
Ideally, its agreed value is the buy price the vendor paid for the stock at the
time of the original purchase.
In this case, and unfortunately this is something we are seeing quite often
in business sale transactions, there was considerable disagreement about
the value of the stock on hand – a difference of 50%.
The buyer basically said: “You have X amount of stock, but a reasonable level
of stock to run this business is Y. I don’t need X amount so I won’t pay for it. I
will pay for Y.”
Beauty (of stock) in the eye of the beholder
Often people who are not adept at managing inventory will have excess stock
because it feels good to know they have it in case someone wants to buy it.
However, they don’t necessarily think about the value of it.
In the meantime the stock may be diminishing in value but, as purchasers
often joke, the vendor thinks they have ‘gold’ sitting on the shelf or in the
warehouse.

7. jpabusiness.com.au
+61
2
6360
0360
7
As a vendor you may say: “I’ve been in this business for many years. If you
don’t have the stock you can’t sell it. Therefore I would rather have this stock
holding than run short.”
That’s fine. You’ve been in the business for years and understand the cycles,
but the purchaser is just looking at the figures on paper and it seems too
much. Chances are they’ll go with their calculation, and often times this is also
being supported by their advisor.
Beauty is in the eye of the beholder when it comes to stock value and
sometimes that is a very difficult concept to accept during a sale process.
Too little stock also costly
There is, of course, a balancing view point, which is important to consider.
A business that is low on stock is often one that doesn’t maximise its product
sale opportunities.
Therefore a purchaser should always listen closely to an owner when
they talk about stock turn and inventory levels – these are not black and
white issues and every business owner will have a different approach to their
inventory level. These approaches mirror an owner’s risk appetite and way of
doing business.
There is no
right or wrong,
but there are
significant
consequence
s for decisions
about inventory
levels.

8. jpabusiness.com.au
+61
2
6360
0360
8
A timely reminder
The disagreement between vendor and purchaser outlined above represented
a large reduction in the value of the business to the vendor – several hundred
thousand dollars.
It also meant the cash flow the owner had diverted to stock holdings
over the years was lost – he couldn’t get that value back out.
This experience was a timely reminder to me that business owners who do
not actively manage their inventory holdings will find it comes home to
roost when they sell.
If only that inventory had been more closely managed, the business owner, on
exiting the business, would have actually got the value of that inventory back.
They would have realised it either in the purchase price for the stock sold, or
in getting the cash flow back out of the inventory when they were managing it
day to day.
It heightened my awareness and made me keen to warn other business
owners: “Don’t forget inventory, because there’s big dollars to be won or
lost there as a business owner.”
How stock holdings are valued
A purchaser will value your stock holding
based on a calculation of your sales over
a particular period.
They may look at the dollar value of sales
you have made in the past six months or
12 months, then reference that dollar figure
against the level of stock.
For example, you have made $250,000
worth of sales of item A in the past 12
months. However the value of stock on hand
of item A is $350,000.

9. jpabusiness.com.au
+61
2
6360
0360
9
In your industry, a stock holding that represents 12 months’ worth of sales
might be the maximum you need.
In that case, why would they pay for $350,000 worth of stock when they
only need and want $250,000 worth for their first 12 months of trading?
How to ensure your stock holding maintains its value
Inventory can provide positive cash flow, but only if it is managed like a
share portfolio.
For example, most people who have shares will actively look at what those
shares are worth on a daily, weekly or monthly basis to see how they are
trading versus the market.
If the shares are underperforming, they will be sold.
Similarly, inventory must be closely managed and moved on when
necessary.
Don’t be tempted to sell off excess stock quickly
Simply planning to reduce your stock level just before selling your
business, however, is not a good option.
This will reduce the margin on the items sold and create a sudden reduction in
your gross profit, which will negatively impact the Business Maintainable
Earnings (BME).
As we've discussed in other eBooks, BME is a key consideration when
assessing business value.
Rather than losing money on the stock, you will lose money from the business
price.
If you have over-stock or obsolete stock items, they must be sold off gradually,
over an appropriate period of time.

10. jpabusiness.com.au
+61
2
6360
0360
10
Chapter 2: Managing inventory to
maximise value
Comments by James Price
JPAbusiness Pty Ltd
How much stock is too much?
As a rule of thumb, a stock holding that represents 12 months worth of
sales is the maximum needed.
However, it’s very hard to generalise.
Some businesses are import oriented so need to commit to a certain
level of stock to ensure their freight rate is not exorbitant and/or they
have sufficient stock ordered from a single season pre-order. This may cause
lumps in their stock holdings.
At the other end of the scale there are some products that are rapidly
changing in terms of the market acceptance due to changes in
technology.
For example, in the retail
telecommunications sector,
mobile devices, accessories
and related products all
change technology rapidly and
brands are constantly bringing
out new versions.
A 12-month stock holding of
sales in that sector would
be far too extensive. In such
an industry, four to six weeks
might be considered more
appropriate.

11. jpabusiness.com.au
+61
2
6360
0360
11
So 12 months of stock holding is a barometer, but it can’t be a rule. Instead,
use it to trigger further investigation.
In all cases, purchasing in bulk to improve margins should not be
considered in isolation. The relative ease of transport within the global
economy and the speed of obsolescence must also be weighed up.
How to calculate Inventory Turnover Ratio
One of the simple ways of testing your position on inventory is to use the
Inventory Turnover Ratio i.e. stock turn. Stock turn is the number of times
in a year that stock turns, or is sold.
ITR = Annual Cost of Goods Sold/Closing Inventory Value
For example, your annual cost of goods sold is $1.25 million and your
inventory level at the end of the year is $400,000.
Your stock turn is $1.25 million divided by $400,000, which is 2.8 times.
You can then divide the number of days in a year by your ITR (i.e. 365 days
divided by 2.8) which gives you the days of inventory on hand (in this case
130 days). This is the number of days you have before you run out of that item.
ITR benchmarks will vary depending on what industry you’re in. They will
be impacted by things like:
• how quickly stock usually moves;
• how long the sales process is, and
• how long the order process is (to the extent you can just-in-time order
to fill a customer enquiry, versus having stock ready for them when
they need it).
We can’t give you a hard and fast ITR benchmark in this eBook, but it is a
simple ratio to give you a feel for how your inventory is going and to
pressure test whether you’re managing your inventory closely.
You might like to seek more information or assistance from a business advisor
or your accountant as decision support for your inventory management
processes.

12. jpabusiness.com.au
+61
2
6360
0360
12
Hold excess stock at your peril
You may be one of these business owners who takes comfort in thinking “my
inventory of an individual item is three times my annual sales, but that’s great
because you never know, someone might come and want it”.
That’s fine, it’s your decision, but just remember you’ve got cash flow and
working capital tied up in that inventory and that will be impacting your
cash flow.
Also keep in mind that you may think your stock is worth 100% of what it cost
you, but chances are that if you go to sell the business, the buyer won’t give
you 100 cents in the dollar for it.
In fact, it can be quite penalising in terms of what you get back.
Just like in a share portfolio, if you have an underperforming share and
you choose to leave it on the shelf and not do anything about it, eventually
you will get a few of cents per share instead of the dollar you paid for it.
Critical to managing your working capital, and therefore business cash flow, is
to manage your inventory closely, not just for today but for the future, in terms
of the value of your business.

13. jpabusiness.com.au
+61
2
6360
0360
13
Why doesn’t inventory management get the attention it
deserves?
There is a lot of money to be won and lost in inventory management, but there
are a range of businesses, some of them quite large albeit still in the SME
range, that don’t have inventory well recorded in their financial and
business systems.
This may be because to manage inventory well you’ve got to go down to
quite a level of detail around items, sales and stock holdings, and really
think about: ‘have I got enough, have I got too much, what’s my order cycle,
what’s my sales cycle?’
Eventually it becomes second nature because you get a gut feel about
whether you have enough stock or not, but there is quite a bit of analysis
involved.
Assessing your working capital position
In the past two chapters we’ve looked closely at inventory, because it is an
important and often overlooked component of working capital, and therefore
cash flow.
In the introduction we defined working capital as the difference between
current liabilities and current assets.
To understand your working capital position you can use the Working
Capital Ratio (WCR), which is known as the Current Ratio.
Current Ratio = Current Assets/Current Liabilities
The goal is for assets to be more than liabilities (i.e. a Current Ratio of 1.0 or
greater) and the more positive that number, the better in terms of the working
capital position of the business.
Of course, ratios are only as accurate as the figures you use to calculate
them.

14. jpabusiness.com.au
+61
2
6360
0360
14
For example, is your inventory really worth X dollars, or is there obsolete stock,
old stock, or simply stock that is surplus to actual sales levels, that mean the
inventory is worth less than actual face value?
If you’re not completely honest about what your inventory is worth, you could
be fooling yourself about your working capital position.
In the next chapter we'll examine some more ways to manage your working
capital.

15. jpabusiness.com.au
+61
2
6360
0360
15
Chapter 3: JPAbusiness Working
Capital Checklist
Comments by James Price
JPAbusiness Pty Ltd
As business valuers and brokers, and in advising clients on business
performance and aspects relating to financing their businesses, there is a
critical thing we look for: liquidity.
Liquidity is effectively how much cash a business generates and how
stable and frequent that generation is.
We’ve talked in the past about business maintainable earnings (BME or
‘sustainable earnings’) which is essentially a measure of cash generation in
the business.
That ability to generate cash is a critical component when it comes to
determining the value of a business.
A bank will look at BME because it wants to know how much cash is in this
business to service the business’ lending and other commitments.
But a purchaser will also look at BME because they often have to borrow
money to buy the business, so they want to know how much cash is surplus in
the business to meet their likely commitments.
And also, as we’ve often said, owners need to think about the value they get
today in running the business, versus the value they get in the future when
they sell.
So the more cash surplus, the more liquidity in the business, the more
value they’re deriving from the business in their pocket today.
But cash surplus – working capital – also gives a business more options to
grow, invest and change, because it’s not constrained by that four-letter
word: cash!

16. jpabusiness.com.au +61
2
6360
0360
16
Working capital checklist
As a business owner or manager, there are a number of levers you need
to control to successfully manage working capital and drive a successful,
cash-generating business.
We’ve created the JPAbusiness Working Capital Checklist to help you
manage those levers. Use the checklist included here, or download a pdf
version from our website.
JPAbusiness"Working"Capital"Checklist"
s a business owner or manager, there are a number of levers you need to control to
successfully manage working capital and drive a successful, cash-generating business.
Those levers fall into two buckets: current assets and current liabilities.
Use this checklist to assist you in achieving a firm control of your working capital levers and cash
position, so your business proposition is not hampered by poor cash flow.
A
Working(
capital(lever
Definition Management(checklist
CURRENT(ASSETS"
1. Cash
and cash
equivalents
Cash in the
working
account
! If you choose to fund working capital with surplus cash,
ensure you have easy access to surplus funds to meet
commitments.
! Have a buffer over your estimated commitments, if
possible.
2. Short-term
investments
Investments
with a maturity
date of less
than 12
months.
! Consider using a short-term investment strategy if there
are major peaks and troughs in the cash generated in
your business. This may be due to rapid growth, project
mobilisation or other market factors.

17. jpabusiness.com.au
+61
2
6360
0360
17
©"2015"JPAbusiness"Pty"Ltd" This"work"is"licensed"under"the"Creative"Commons"Attribution"4.0"International"License.""
ABN"62"150"534"099" To"view"a"copy"of"this"licence,"visit"http://creativecommons.org/licenses/by/4.0/."
Working(
capital(lever
Definition Management(checklist
3. Accounts
receivable
Debtors
! Ask the hard questions of a new customer regarding
payment history. Consider tightening payment terms
until they’ve established a positive track record. Use
credit rating agencies.
! Set standard timing for invoicing and stick to it.
Document and agree on your payment terms (‘terms of
trade’).
! If you send out invoices with 14-day payment terms,
then on day 13 make sure there is a calling program. Call
all your key customers due for payment the next day and
speak to the decision maker or accounts person
responsible.
! Monitor payment and resolve disputes quickly.
! Unless you’re a bank, don’t act like one. Some
businesses have payment terms that state ‘the payment
period is X days – if the account is not paid in X days the
customer will be charged interest at a daily rate of Y per
cent’. Interest being charged doesn’t necessarily help
your cash flow!
4. Inventory Stock on hand
! Record your inventory.
! Record, item by item, what monthly and annual sales are
versus your inventory holding.
! Ensure your inventory holding matches your sales and
supply cycle.
! Review your inventory at least once a month to
appreciate whether it’s over- or under-valued versus
your business needs.
! Be aggressive about writing down inventory and/or
divesting or removing obsolete items.
5. Prepaid
expenses
Services
purchased
upfront
! Be selective about which services are pre-paid. You may
receive a margin or cost benefit through such a strategy,
but remember you are potentially tying up working
capital.

18. jpabusiness.com.au
+61
2
6360
0360
18
©"2015"JPAbusiness"Pty"Ltd" This"work"is"licensed"under"the"Creative"Commons"Attribution"4.0"International"License.""
ABN"62"150"534"099" To"view"a"copy"of"this"licence,"visit"http://creativecommons.org/licenses/by/4.0/."
Working(
capital(lever
Definition Management(checklist
CURRENT(LIABILITIES
6. Accounts
payable
Creditors
! Meet your commitments when they’re due.
! If you wish to pay accounts early, ensure you receive a
better margin for doing so.
! If you have a track record and a relationship with
suppliers, look for opportunities to extend your payment
terms. Document and agree a fair arrangement upfront.
! Spot opportunities to remove or minimise timing gaps
between debtor and creditor payments.
! Talk ahead of time to creditors if you have cash flow
problems.
7. Short-term
debt
Line of credit
or overdraft
! If you choose to fund working capital with a line of credit
(debt funding), ensure you have easy access to surplus
funds to meet commitments as and when they fall due,
in case limits are pressured.
! Have a buffer in your line of credit over your estimated
commitments, if possible.
! Try and achieve a credit position once a month with your
overdraft. If this is not frequently achieved it may mean
you have core debt in your overdraft rather than simply
working capital. If so, talk to your financier about loan
restructure options.
8. Current
commitments
Commitments
within next 12
months e.g.
interest on
five-year loan
! Budget for major loan interest and repayment
obligations, as these can cause ‘lumpy’ impacts on cash
flow.
! Plan ahead for residual payouts on plant and equipment
leases – another potential heavy impact on cash flow.

19. jpabusiness.com.au
+61
2
6360
0360
19
©"2015"JPAbusiness"Pty"Ltd" This"work"is"licensed"under"the"Creative"Commons"Attribution"4.0"International"License.""
ABN"62"150"534"099" To"view"a"copy"of"this"licence,"visit"http://creativecommons.org/licenses/by/4.0/."
If you would like to learn more about the business advisory and broking services
offered by JPAbusiness, please contact the team by visiting
www.jpabusiness.com.au/contact-jpabusiness
Please"feel"free"to"post"this"template"on"your"blog,"or"email,"tweet"and"share"it"with"your"network.""
Working(
capital(lever
Definition Management(checklist
9. Salaries Include
accompanying
payments e.g.
superannuation
! Employees are a critical part of your business – ensure
you always have cash flow to meet wage and salary
commitments.
! Budget and provision ahead for other statutory
obligations to employees, such as superannuation
payments and accrued entitlements for annual leave and
long-service leave.
10. Taxes and
regulatory and
statutory
payments
GST, income
tax, etc.
! Actively manage and monitor your tax, regulatory and
statutory payment obligations. Have your team estimate
these ahead of time when cash flow is tight to ensure
you are able to meet commitments.
! If you suspect you’re going to be seriously challenged in
meeting these commitments and can’t see any
alternatives, talk to your accountant or advisor about
contacting the ATO about a possible payment plan.
! If you get behind and overdue, you are too late. Missing
payments to the tax office will negatively impact your
standing with both the ATO and your bank.

20. jpabusiness.com.au
+61
2
6360
0360
20
Chapter 4: How cash flow and working
capital impact business value
Comments by James Price
JPAbusiness Pty Ltd
Working capital, cash flow, inventory, debtors, creditors – these are all day-to-
day business levers you need to think about as a business owner.
Sometimes, we’re so caught up in the wash of business, trying to run the thing,
we take these levers for granted.
We also take for granted the fact that while these levers contribute to the daily
value of our business, they’re also critical to our succession and exit plans
– to our ultimate business value.
What we look for in the due diligence process
At JPAbusiness we often undertake commercial and financial due diligence
for purchasers looking to buy businesses.
Cash flow and working capital, accounts receivable and payable, and
inventory are some of the key things we examine in a due diligence process:
Surplus cash – How much
surplus cash does the business
generate and is that cash
generation sustainable?
Often that simple calculation will
feed into our view of Business
Maintainable Earnings (BME) and
therefore significantly impact our
perception when advising the
purchaser of what the business is
worth.

21. jpabusiness.com.au
+61
2
6360
0360
21
The debtor’s ledger – Also known as accounts receivable, these are
the people who owe you money.
We look at the strength of that ledger and the ability over time for your
customers to pay what they owe to you, on time.
Accounts receivable is one of those assets you might assume can be
taken at face value, but what if your debtors aren’t meeting your terms?
Effectively, the debtor’s ledger is a portfolio and if it is out of order by
large, significant amounts, you will be penalised.
This is because the purchaser is taking on that portfolio of customers and
their poor performance in terms of payment.
For instance, if your payment terms with customers are 30 days and your
debtor’s ledger shows that 30% of the value of your debtors are
overdue by 90 days or more, that will impact your working capital and
cash flow.
The risk that a purchaser will perceive is that they won’t get 30% of
debtors on a monthly basis, based on what’s occurred to date. We will
respond by marking down the value of your debtor’s ledger, from a
due diligence perspective.
That’s why a day-to-day lever in this area is so critical to you, the
owner.

22. jpabusiness.com.au
+61
2
6360
0360
22
Inventory – We’ve talked about the face value of inventory versus the
real value and how vendors tend to think they have ‘gold’ on the shelves.
Don’t fool yourself by thinking you’ve got X dollars of inventory when
the reality is, to run your business successfully, you only need Y dollars.
Be honest and upfront with yourself regarding what the real value of your
inventory is.
Put yourself in a purchaser’s position and think: “If I was to buy my
business today, how much inventory would I really be prepared to pay for
and at what dollar value?”
If you’re not sure, get some advice around what a reasonable inventory
holding is, how to ensure you get the most value out of your inventory and
how to dynamically manage it.
All these components are closely watched in
a due diligence process by a purchaser and
their advisor looking to buy a business.
We know because we run those processes for
clients and those components go heavily to
making up the value exchange in a business
transaction. They’re all levers that can be
heavily influenced by a business owner.
Yes, they are impacted by market forces, things that happen to suppliers and
customers, but largely they can be influenced by you. Ignore them at your
peril.
Address them, utilise them, and you will be rewarded with a business that
generates cash day to day, and builds value over time.
If you would like to learn more about the business broking and advisory
services offered by JPAbusiness, you can contact the team by visiting
www.jpabusiness.com.au/contact-jpabusiness