Why Your Inventory May Be Hiding a Cash Problem

Business owners often tell me the same thing in my office. The profit and loss statement looks healthy, the shelves are full, and the checking account is somehow thin. Inventory is the first place I look when I hear that. A stockroom packed with product feels like wealth, but every unit on those shelves is money you already paid out that has not come back yet. Until that product sells, it is cash sitting in a different form, and it cannot cover payroll, rent, or your next supplier invoice.

Stock That Sits Is Cash That Left

When you buy inventory, you pay your supplier now, but the cost does not become an expense until the goods sell. The IRS says the cost of merchandise you purchase is the invoice price less appropriate discounts, plus transportation or other charges incurred in acquiring the goods. That means freight on a rush order becomes part of what each item costs you. Picture a $20,000 purchase where only $12,000 of it sells this quarter. Your cash dropped by the full $20,000, but your reported cost of goods sold reflects only the portion that left the building.

The $8,000 that remains is not gone, but it is stuck. It also costs you money while it waits through storage, insurance, handling, and the chance that it becomes harder to sell next season. Products age, styles change, and customers move on. Owners often respond with deep discounts later, and the margin that looked solid on paper disappears. A bank balance that keeps shrinking while sales hold steady is a common sign that too much cash is parked in slow moving stock.

Purchasing Habits That Quietly Drain Cash

Most inventory trouble starts at the purchase order. A volume discount looks like savings, but if the extra units take six months to sell, the discount rarely covers the cost of tying up that cash. Buying to keep shelves looking full, ordering on instinct rather than on sales history, and reordering the same quantities out of habit all produce the same result. You end up deep in the products that sell slowly and thin in the ones that sell fast.

I encourage clients to look at purchasing the way they look at any other spending decision. Before placing an order, ask how many weeks of sales it represents and what that cash could do for the business if it stayed in the bank. Ask suppliers about payment terms, because paying thirty days after delivery instead of at delivery gives you time to sell some of the goods before the bill is due. Review the sell through rate on each product line before you reorder it. A few minutes with last quarter's sales report will often change what you buy.

When the Count Is Wrong, the Numbers Are Wrong

Your cost of goods sold is built from three pieces. You start with the inventory you had at the beginning of the period, add what you purchased, and subtract what is left at the end. Because of that formula, any mistake in the ending count flows straight through to your gross profit and your taxable income. If you overstate what is on the shelf, cost of goods sold looks smaller and profit looks larger, so you may pay tax on income that never turned into cash. If you understate it, you report less profit than you earned, which creates a different set of problems with lenders and with the IRS.

Counts go wrong for ordinary reasons. Items get damaged, returned, miscounted, mislabeled, or taken. The National Retail Federation reported that inventory loss, known as shrink, averaged 1.6% in fiscal year 2022, equal to $112.1 billion in losses among the retailers it surveyed. Those figures come from large retail brands with loss prevention teams, so a small business with one or two people handling stock has every reason to take the issue seriously. Some small businesses are not required to track inventory under the full tax rules. Under current law, a business with average annual gross receipts of $32 million or less over the prior three years generally meets the small business threshold for 2026. Even so, you still need accurate counts to know what you own, what you owe, and what you can afford to buy next.

What the Tax Rules Say About Stock That Will Not Sell

Tax rules do give you a way to recognize the lost value of goods that have dropped in worth, but the rules are specific. Under the lower of cost or market method, you compare the market value of each item on hand on the inventory date with its cost and use the lower value. One well known illustration involves a business with $25,000 of inventory at cost that is worth $15,000 under the lower of cost or market method. That business reports $10,000 less income in the first year and $10,000 more in the second, which shifts the timing of the tax rather than eliminating it.

Goods that cannot be sold at normal prices get their own treatment. IRS Publication 538 describes these as items with damage, imperfections, shop wear, changes of style, odd or broken lots, or similar causes, and says they should be valued at their bona fide selling price minus the direct cost of disposing of them. The word bona fide matters here. In Thor Power Tool Co. v. Commissioner, the Supreme Court upheld the IRS when a company wrote down what it regarded as excess inventory but continued to hold the goods for sale at original prices. A write down based on your own estimate, with the goods still priced the same on the shelf, will not hold up. Evidence does, such as sales at reduced prices after year end, donations, or disposal, along with records showing what happened. A change in how you value inventory generally requires IRS consent, so talk with your CPA before you change anything.

A Simple Routine to Catch the Problem Early

You do not need special software to get ahead of this. Start with an aging report each month that shows how long each product has been on hand, and mark anything that has not moved in a set number of months for a decision. That decision might be a markdown, a bundle with a fast seller, a return to the supplier, or a donation. Count a slice of your stock every month so that you cover everything over the course of the year, and compare what you find to what your books say. Differences are information, and they are far easier to trace when they are small and recent.

Pair that routine with a review of purchasing before you pay each supplier invoice. Look at what is selling, what is not, and how many weeks of stock you hold in each category. With the year coming to a close, now is a good time to schedule a conversation with your CPA about your count, your slow movers, and any write downs you are considering. Decisions made in October and November leave room to document them properly, and a clear picture of your inventory is one of the best ways to understand where your cash went.