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For product-based businesses, inventory is often the second-largest use of cash after payroll. Too much inventory ties up working capital that could cover payroll, marketing, or an emergency. Too little loses sales. The goal is holding the minimum inventory required to meet demand, no more, no less.
The Metrics That Actually Matter
| Metric | Formula | Reasonable Target |
|---|---|---|
| Inventory Turnover | COGS ÷ Average Inventory | 6-12x per year |
| Days Inventory Outstanding | Average Inventory ÷ COGS × 365 | Under 60 days |
| Inventory Carrying Cost | Storage + insurance + obsolescence + capital cost | 20-30% of inventory value per year |
| Stockout Rate | Stockouts ÷ Total Orders | Under 2% |
Days Inventory Outstanding is one of the three components of the cash conversion cycle, if this number is high, it's directly extending how long your cash is tied up.
Six Ways to Free Up Cash Trapped in Inventory
- ABC analysis. Not all inventory is equal. Classify by value and velocity: A items (roughly 20% of SKUs, 80% of revenue) get tight control and frequent review; B items get moderate control; C items get minimal control and can be bulk-ordered.
- Just-in-time ordering. Order inventory to arrive just before it's needed rather than weeks in advance. Reduces carrying cost and obsolescence risk, but depends on reliable suppliers and reasonably accurate demand forecasting.
- Safety stock sized to actual variability, not a round number. Hold enough buffer to prevent stockouts without trapping more cash than necessary: (max daily usage × max lead time) − (average daily usage × average lead time) is the standard formula.
- Liquidate dead stock. Inventory that hasn't sold in 6-12 months is dead weight. Bundle it with fast movers, run a clearance sale, sell to a liquidator, or donate it for a tax write-off, anything beats letting it sit.
- Improve demand forecasting. Historical sales data and seasonality patterns beat gut-feel ordering. Even a simple moving average in a spreadsheet outperforms ordering the same amount every month regardless of trend.
- Negotiate vendor terms on inventory itself. Consignment arrangements, extended payment terms, or return rights shift inventory risk onto the vendor and keep your own cash free longer.
Technology Can Automate Most of This
Modern inventory and expense management tools can automate demand forecasting and reorder points instead of running it by hand. See payment and workflow automation tools for small business for how to evaluate options without over-buying software you won't use.
Frequently Asked Questions
How much cash is actually tied up in inventory?
Multiply your average inventory value by your carrying cost percentage. Most businesses carry 20-30% of their inventory value in carrying costs annually, storage, insurance, obsolescence, and the opportunity cost of that capital sitting still.
Should I drop slow-moving products?
Not automatically. Try bundling, repositioning, or discounting first. Drop a product only once it's consistently losing money, not just moving slowly.
What's the biggest inventory mistake small businesses make?
Overordering to hit a volume discount. The discount rarely covers the carrying cost of the excess inventory it creates.