A company's working capital includes inventory, and increases in inventory make working capital increase. Working capital is calculated as the difference between a company's current assets and current liabilities. Inventory is classified as part of the current assets since there is an expectation that this asset is going to be consumed and produce economic benefits within a year.
Inventory represents products a company owns and plans to use in its production process within the next year. Inventory can be in the form of raw materials, work in progress or finished goods. Raw materials can include commodities such as metal or oil, while work-in-progress inventory refers to goods that have undergone a certain level of processing on a company's production line but are not finished goods yet. Finished goods are products that are available for sale by a company. Certain companies such as clothing retailers do not have raw materials or work in progress included in their inventories due to the nature of their business.
Keeping inventory on hand is not only costly, as a company has to incur warehousing expenses, but it also presents an opportunity cost as the company could have done other profitable things with the funds invested in inventory. Also, inventory tends to become obsolete or even spoil, resulting in balance sheet declines and charges on a company's income statement.
Working Capital and Inventory
Inventory is an integral part of a typical company's current assets and working capital. For certain types of companies, such as general retail and grocery, inventory can represent a substantial part of the current assets with over a 70% share. For companies in the manufacturing industry, inventory may claim less than 10% of the current assets. Working capital can fluctuate significantly from year to year if a company underestimates or overestimates demand for its products. Also, many companies shift to just-in-time (JIT) inventory management, resulting in a smaller inventory share in a company's working capital.