What Is Inventory, Is It Working Capital?
A company's working capital includes inventory. Inventory falls into three categories: items held for sale by a company as part of its daily business, items that are in the process of being prepared for sale, or materials or supplies that are intended for consumption in the production process.
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, or short-term assets, since there is an expectation that this asset is going to be consumed and produce economic benefits within a year.
- Inventory is part of a company's working capital.
- Inventory is classified as current assets because it is typically consumed within a year as part of the production process
- Inventory incurs warehousing costs and is considered opportunity cost.
How Inventory Works
Inventory represents products a company owns and plans to use in its production process within the next year. Inventory can be in one of three forms: 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 yet finished goods. 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. However, inventory on had 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.
Special Considerations: Inventory to Working Capital Ratio
The inventory to working capital ratio is used by investors as an indicator of a company's operationally efficiency. The ratio is calculated by dividing inventory by working capital. A value of 1 or less implies a company is highly liquid in terms of its current assets or it could mean that that there is insufficient inventory to meet productivity demand.
On the other hand, a high inventory to capital ratio could mean that a company has too much inventory. Too much inventory is costly because it increases warehousing costs and can lead to wastage.
In summary, inventory is an integral part of a typical company's current assets and working capital. For certain types of companies, such as those in the general retail sector, inventory can represent a substantial part of current assets with over a 70% share. For manufacturing companies, 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.