Too often, we antique dealers find ourselves in the position of being “inventory rich and cash poor.” We have a lot of money tied up in inventory but not enough cash to pay our bills and write ourselves a regular paycheck.
We try various tactics to squeeze more cash from our inventory: We mark-down items, advertise a “big sale,” raise prices when we can and set up booths at antique shows and/or flea markets to increase our exposure. Sometimes, when we’re hard-pressed to pay the bills and need instant cash, we sell items at deep discounts to other dealers.
Squeezing more cash from inventory isn’t as simple as “selling more.” All retail stores reach a sales ceiling that’s tough to penetrate. In some years sales are a little higher and in other years sales are down a bit. But, for the most part, our stores tend to stay pretty much in the same range year after year. It could be that in our particular market, we have all the market share that we’re going to get. And, without more financial resources, we find it tough to break through to the next level.
Raising prices (or otherwise increasing selling margins) won’t create more cash, either. Maybe it will in the short-term, but raising prices will also result in some lost sales. Chances are you’re already doing all of these things to get more cash out of your inventory but still have cash flow problems. Taken together, the above tactics won’t fix a cash flow problem.
But I have some good news for you: There’s a way to improve the return on your inventory investment and free up more cash without increasing sales, raising prices or “buying better.” That way is to focus on GMROI, or Gross Margin Return on Inventory. Focusing on GMROI, simply put, is to adjust your inventory levels, turnover, prices, margins and sales to create the amount of cash that you need to pay all of your expenses, grow your business and have enough money left over to pay yourself handsomely.
When you understand GMROI, you may discover that:
• You can make more money from fewer sales
• You can make more money with reduced margins (lowered prices)
• You need less inventory to hit your sales goals
• You have more cash available to reduce debt and grow your business.
Before I get into the specifics of how GMROI works, let me post a warning: GMROI is not a magic wand that will fix a cash flow problem. Rather, it is a tool that will give you insight into how certain variables work together to give you the best return on your inventory investment. GMROI calculations allow you to manipulate those variables so you can see clearly what must be done to reach your objectives. Like any tool, its effectiveness will depend on how well you use it. Using it well requires thoughtfulness on your part.
GMROI answers the question “How much money do I get back for every dollar I invest in inventory?” The Gross Profit (or Gross Margin) that is created when you make sales needs to provide sufficient money to operate and grow your business and make a profit for the owners. It makes sense to squeeze all the dollars you can from your inventory. GMROI allows you to discover ways to do this with raising sales or prices.
GMROI is calculated from two numbers: Your Gross Profit and your Average Inventory.
On your income statement, your sales revenue displays as Sales, and the amount you paid for your inventory displays as Cost of Goods Sold (COGS). The difference between Sales and Cost of Goods Sold is your Gross Profit. Gross Profit is the same thing as Gross Margin; Gross Profit is usually expressed in dollars, and Gross Margin as a percentage of sales. I will use these terms interchangeably, because they are two ways of expressing the same thing.
Here’s how to calculate your GMROI, in three easy steps, using your annual Gross Margin (in dollars) and your average Inventory at cost. If you don’t have actual figures for these, use your projected figures.
Step #1: Calculate Gross Margin dollars. The formula is: Sales minus Cost of Goods Sold = Gross Margin. For example (keeping the numbers simple for the sake of the example), if your total sales for the year were $200,000 and your Cost of Goods Sold was $100,000, then $200,000 minus $100,000 = $100,000. Your Gross Margin would be $100,000.
Step #2: Calculate Average Inventory at Cost. To figure your average inventory for a year, add up your ending inventories (at cost) for each month of the year, plus the ending inventory (at cost) for the previous year. Then, to get the average, divide the total of those inventories by 13, the number of inventories in the sum. Let’s assume, again keeping it simple, that the sum of all those inventories (including last year’s fiscal year-end) was $1,300,000. Then, using the formula, $1,300,000 divided by 13 = $100,000.
Step #3: Calculate GMROI. Here’s the formula: Annual Gross Margin Dollars ($100,000) divided by Average Inventory at Cost ($100,000) equals GMROI. So, $100,000 divided by $100,000 = 1.
The “math-adverse” among us can find a GMROI calculator online. Just follow the directions and enter your numbers.
“So what?” you say. “What does that tell me?”
What it tells you is that for every dollar you have invested in inventory you are getting a dollar back to pay all your expenses and buy new inventory.
Of course, no one can maintain a business at that level; a dollar back for every dollar spent on inventory won’t even give you enough money to replace the inventory, much less pay the bills. But, using the $1 figure as a baseline, and keeping Sales and Gross Margin the same, let’s see what happens to GMROI as we adjust inventory levels alone:
– COGS: $100,000
$100,000 Gross Margin
A $100,000 Gross Margin divided by $115,000 Average Inventory = 0.87. Your inventory went up by $15,000. Since you have more money invested in inventory and your sales and margins have remained the same, the return on your inventory investment went down to 87 cents for every dollar invested. At this level you’re digging a financial hole.
Let’s take one more look at the effect of an inventory increase, using the same Sales and COGS above:
A $100,000 Gross Margin divided by $130,000 Avg. Inv. = 0.78. Your inventory went up by $30,000, and since your sales and margins didn’t change, the return on your inventory investment went down to 78 cents for every dollar invested.
Now let’s see what happens with a reduced inventory level, again using the same numbers:
A $100,000 Gross Margin divided by $90,000 Avg. Inv. = 1.11. You reduced your inventory by just 10 percent (to $90,000) and increased the return on your investment to $1.11 for each dollar invested.
Let’s try this one more time, with a bigger inventory decrease:
A $100,000 Gross Margin divided by $50,000 Avg. Inv. = 2.0. Cut your inventory in half, and your GMROI doubles.
Not only are you getting a better return on your inventory investment, you just freed up $50,000 in cash.
Makes sense, doesn’t it?
You’re not trying to keep your inventory at the $100,000 level, so you’re spending less cash on inventory. Your sales have remained the same, and the cost of the merchandise that you sold remained the same. The only difference is that you are turning your inventory over faster. (An “inventory turn” is a theoretical number; it is the amount of time it takes to sell through your average inventory at your current sales level.) You no longer carry a 12-month supply of inventory; you carry a six-month supply. Money that would have gone into maintaining a high inventory level can now be used to pay your bills.
When sales and margins stay the same, you can create more spendable cash by reducing the size of your inventory and turning it faster.
See Chart One for how the GMROI looks using the same numbers, but increasing the inventory turns.
Think of “Targeted Turns” as “months of supply.” One turn means you have a 12-month supply of inventory on hand; two turns means you have a six-month supply, and so on. Does a six-month supply of inventory sound like too little for you? It’s not, really. Industry benchmarks for used merchandise dealers show that they routinely turn their inventory four times per year; in other words, they sell from a three-month supply of inventory. Some retailers (grocery stores, for example) turn their inventories 12 times a year or more depending on the department. It’s also notable that in 2013, used merchandise dealers, on average, had a GMROI of more than $5 on four inventory turns.
The important point to know is that by adjusting your inventory levels and turns you can get a better return on your inventory investment and free up cash to use for other purposes. Ideally, you should play around with your sales, margins and inventory turns on a spreadsheet to see what combination works best in your situation.
Have a look at how the GMROI can vary depending on sales and inventory levels, margins and inventory turns: See Chart Two.
That the GMROI can vary so much is why thoughtful consideration should be given to your results. What’s the best approach for your particular business? Should you:
– Raise your gross profit margin percent?
– Increase inventory turns?
– Decrease the size of your inventory?
– Increase sales?
– Or, some combination of the above?
Remember, there are other issues associated with your inventory that need to be considered in your analysis. The size and depth of your inventory makes a clear statement about your business. For starters, you can’t sell what you don’t have. If you’re operating a bricks-and-mortar store, you want your customers to have some selection. If you sell online using sites like ETSY or eBay, the visual impact of your inventory is less important because it will never be seen all at once.
On the other hand, low inventory turns might indicate that you have too much dead stock. If you are holding on to inventory that you bought more than a year ago, get rid of it (with the exception of rare pieces). Dead inventory builds like silt in a river bed: Little by little, unnoticed, until the day it grounds your ship on a sandbar. Dead inventory equals inaccessible cash.
Forty percent of small businesses that file for bankruptcy are profitable; they just ran out of cash. The biggest “cash trap” that small retailers have is their inventory. GMROI is one tool that can be used to keep the cash flowing and your business growing.
Previously published in Antique Trader Magazine
Originally posted 2014-03-21 11:20:00.