Accounting will code inventory invoices as expenses for several reasons. You may not be aware it’s happening. And you may not be aware of the implications and benefits of fixing it.
Before we go into the benefits, let me outline the consequences. When you make this mistake in your accounting, you
- signal a lack of sophistication to acquirers
- lower the amount senior lenders will give you
- underinvest in acquisition
- overbuy inventory
- borrow more than you need
- pay more in interest than you should
- take too much dilution
- and make worse decisions based on your understanding of your margins.
When I see gross product margin fluctuating substantially month to month I suspect accounting is miscoding inventory payments as COGS as opposed to capitalizing them and having the cash impact flow through in the correct period.
Here’s what often happens. Inventory has multiple states as it moves through a system. It can be raw materials, work in progress, inventory in transit and inventory in your warehouse ready to sell. Inventory in the warehouse should be on the books at the lower of cost or Net Realizable Value. This all requires tools or platforms, systems, people and coordination between ops and finance. It also requires some time and effort by people to get right. When any of those aren’t available, the accountant is forced to make simplifying assumptions. And one of those simplifying assumptions is booking inventory payments, inbound freight payments, packaging payments, tariffs and duties as expenses as opposed to balance sheet items that are then matched to the sales of the inventory.
The goal of accrual accounting is to match the expenses to the revenue in the period the revenue happened. And when the accountant expenses as opposed to capitalizes, they sneak a little bit of cash accounting into your otherwise accrual books. It sounds innocuous, but it isn’t. Let’s look at the 4 biggest impacts.
#1 Acquirers and senior lenders will pick this up.
You aren’t just telling them that your cash forecasting is off, you are telling them that you don’t have the proper systems in place. This adds risk. And risk is mitigated through lower valuations, lower credit limits, higher rates and stricter covenants. You also are telling that acquirer or lender to dig deeper. If you don’t have something so capital intensive as inventory properly accounted for, what other issues are lurking in your system?
#2 You may be underinvesting in acquisition.
A mantra in today’s DTC thinking is to free up as much margin as possible in order to invest more in ads. The brand that can spend 40% of net sales on ads will do better than the brand that can only spend 30%. This is one of the prime drivers to slash OpEx. When your product gross margin fluctuates because of when you pay invoices (the miscoding) you overstate COGS some months and understate in others. This unnecessary volatility requires a margin of safety in how much you can budget for ad spend. Correcting this doesn’t magically produce more cash. It just gives you a more accurate view of your margin which could then lead to a larger ad budget. The caveat here is that you really should be understanding your unit economics by building up from landed cost, so don’t forego that work!
#3 The pattern for your intuition for your margins is wrong.
As a founder, you build intuition by observing results. Your gross product margin should be fluctuating month to month because you raised prices, had a sale, changed your product mix etc. It shouldn’t be changing based on when you sent a wire to your supplier. The better your product margin reflects reality, the sharper your intuition and the faster your decisions.
#4 You may consistently overstate the inventory needed in the future, overestimate your capital needs and underestimate your cashflow.
If your financial modeling uses forward COGS and a Days Inventory assumption, the miscoding will compound the overbuying in the model which in turn will use more cash and potentially call for more capital than is actually required. The issue here is one of capital efficiency and can lead to paying for more capital than needed in the form of interest and dilution.
If you like this and correct your accounting, you are exactly the type of company we want to talk to about inventory finance. We provide more growth capital in the best structure over time allowing you to grow sales, EBITDA, Free Cash Flow and valuation faster than any alternatives. Reach out to us at Elephant Herd Capital.
If you need help with this, check out Herd CoPilot which is AI + an expert network to help you solve your brand’s finance and capital challenges today.