Question

Page 96 example: Making this even trickier is that sales can be “lumpy,” and not increase smoothly over time. If increasing sales cause the retailer to increase inventory (perhaps to not lose sales due to not having enough inventory on hand), then assets increase. What was the potential problem with that?

Answer 1

It is essential for any business to hold sufficient inventory to meet customer demands. However, too much investment in inventory can lead to blockage of funds which can be utilized by the company for other purposes. In other words, while additional inventory would result in an increase in the the value of overall assets (specifically current assets) of the company, it would put additional pressure on the company's cash balance (causing an equivalent reduction in the value of company's current assets) or result in creation of liability (in the form of accounts payable) which the company would be required to pay off in the near future. Holding excess inventory would also result in extra costs for the company (also known as inventory carrying costs such as rent paid for warehouse, cost of electricity and other utilities, insurance, etc. ). Simply maintaining high inventory levels is not the correct approach. The focus should be on maintaining the inventory of those items that are in line with the market demand and current customer preferences. Therefore, it is extremely important for any company to estimate/predict the sales (through a sales budget) for different periods and plan its inventory production/procurement accordingly. The company should also try to reduce its inventory levels for slow moving items and focus on production/procurement of fast moving goods which would result in quick conversion of inventory into cash.