Inventory Accounting and Cash Flow: When Loans Help

Posted at 06:32h in Small Business Financing by Kelly Hillock

The difference in timing between how you account for inventory and when actual cash flows into or out of your bank account makes a difference in determining whether you can self-fund your cash flow needs or should seek a loan.

The IRS generally requires you to use an accrual method of accounting for inventories, meaning that you recognize both revenue and the cost of goods sold (COGS) when you sell a product. The timing of sales is often different compared to when cash is sent to suppliers or received from customers.

You might use cash for raw materials in January to make the inventory you’ll sell in July (where you’ll account for revenue and COGS) and receive cash for in September. This is why some small business owners wonder how sales can be so good but cash always seems tight.

Fortunately, you can take steps to improve cash flow from inventory and self-fund in some situations, while other times, you can benefit from taking on a loan. We’ll go through some common situations that you might face to help you think through cash flow management and see when an inventory loan makes sense so that you have the products you need for sales to cover rent, wages, and other expenses.

Stocking up for the busy season

If you’re a manufacturer that sells to retailers, stocking up for the busy season means cash flows out of the business well before it comes back from sales, making it tough to meet other expenses like payroll and rent.

If your production timeline is short enough, you can self-fund inventory cash flow needs by negotiating longer payment terms with suppliers and shorter terms with customers. If customers pay net-30 and you pay suppliers net-60, it gives you a 30-day buffer before you need actual cash on hand. The table below shows how cash flows in and out across two sales with these terms:

Revenue per product is $100,000.

COGS is $50,000.

Customers pay net-30.

You pay suppliers net-60.

Day	Customer (1)	Customer (2)	Cash In	Cash Out	Cash Balance
0	Purchase inventory		N/A	N/A	$0
30	Make sale	Purchase inventory (2)	N/A	N/A	$0
60	Collect from customer net-30 Pay supplier net-60	Make sale (2)	$100,000	$50,000	$50,000
90		Collect from customer net-30 (2) Pay supplier net-60 (2)	$100,000	$50,000	$100,000

By negotiating the different timing of terms, cash flows into the business just as you need to send it out, so you’re always cash flow positive. You can get even better cash flow by closing the gap between inventory purchases and sales. The table below uses the same terms but a faster sale:

Day	Customer (1)	Customer (2)	Cash In	Cash Out	Cash Balance
0	Purchase inventory		N/A	N/A	$0
15	Make sale	Purchase inventory (2)	N/A	N/A	$0
30		Make sale (2)	N/A	N/A	$0
45	Collect from customer net-30		$100,000	$0	$100,000
60	Pay supplier net-60	Collect from customer net-30 (2)	$100,000	$50,000	$150,000
75		Pay supplier net-60 (2)		$50,000	$100,000

With the negotiated terms and a faster speed of sale, you both get to positive cash flow sooner (day 45 vs day 60), and you have a higher average cash balance throughout the period that you can invest in finding more customers.

Not selling enough inventory and having immediate expenses

Whether you didn’t sell enough inventory because demand was light or because of uncontrollable situations like the weather disrupting tourism, you still need cash to pay your employees, suppliers, landlords, and others. This is when a small business loan can help fill your cash flow gap, using the example from above:

You began the period with $25,000 in cash from prior sales.

Payroll, rent, and fixed costs are $40,000 per month (paid semi-weekly).

Customer (1) sale doesn’t close until day 45.

Light demand means customer (2) closes day 45 with 10% discount ($90K sale).

The table below shows how you’d run out of cash before you closed the first customer:

Day	Customer (1)	Customer (2)	Cash In	Cash Out	Cash Balance
0	Purchase inventory		N/A	N/A	$25,000
15		Purchase inventory (2)	N/A	$20,000	$5,000
30			N/A	$20,000	-$15,000
45	Make sale	Make sale (2)	$0	$20,000	-$35,000
60	Pay supplier net-60		$0	$70,000	-$105,000
75	Collect from customer net-30	Collect from customer net-30 (2 Pay supplier net-60 (2)	$190,000	$70,000	$15,000

A line of credit is ideal for situations where delayed sales and lighter demand (like above) happen unexpectedly. You can draw cash from the line of credit as needed, like on day 15 when you realize you won’t be able to collect any cash from customers before your balance turns negative.

You only pay interest on a line of credit when you have a balance outstanding. So even if you don’t need the cash right now, it’s a good idea to start the application process to have it available when you need it.

Receivables financing is another option where the customer invoice serves as collateral for a short-term business loan. You can also do what’s called invoice factoring where you get immediate cash by selling the invoice to a third-party for a discount, and they collect from the customer.

Make sure to compare the total amount of interest instead of the interest rate versus the factoring discount if you go this route. Here’s a 20% receivables financing loan paid back after 30 days compared to a 3% discount on invoice factoring:

	Invoice Amount	Rate	Financing Cost	Cash You Keep
Receivables Financing Loan	$20,000	20% APR	$336.03	$19,663.97
Invoice Factoring	$20,000	3% Factoring Discount	$600	$19,400

Even though the factoring discount is much lower than the APR, you keep more cash with the loan because you pay off the loan quickly.

Expanding retail locations with both self-funding and a loan

You’ll need to forecast how much cash flow it takes to stock the new store, hire and train staff, cover rent, and turn on the lights all before the doors open. Then compare this to the available cash flow from your existing locations to see if you can self-fund or if you need a loan. If your current location doesn’t have enough free cash, you can use the self-funding tactics and loans mentioned above, or you can tap into these other funding options:

Working capital loan: You can use this short-term business loan for inventory as well as payroll, rent, utilities, or other near-term needs. Interest rates can be higher than other loans, but by repaying the loan quickly as sales come in, you will keep the total amount of interest paid low.

Inventory financing loan: The inventory serves as collateral for this loan to keep rates low and make approval easy, but you can’t use it for other business needs. If you have limited cash, you can use an inventory finance loan to stock the store, while using cash on hand for the other expenses.

Equity financing: This type of funding isn’t a loan. It’s an investor putting money into the business for a share of profits. It gives you cash to use for various business purposes, and it lowers your risk from losses, since you don’t pay it back like a loan and instead pay a portion of profits to the investor. Plus, an equity investor can participate like a business partner, providing access to networks and expertise that can help your expansion plans.

The difference in timing between inventory accounting and cash flow can cause issues when it comes to making payroll, paying rent, and covering other necessary expenses, if not managed properly. Tactics like negotiating timing of payment terms, preparing for surprises by getting a line of credit, and using other funding sources as needed can cover the cash gap in most situations