Inventory and working capital have a symbiotic relationship in business. Working capital is a financial formula that measures a company’s operating liquidity. The basic working capital formula is current assets minus current liabilities, with inventory being part of a company’s current assets. Companies that derive a large portion of sales will often have copious amounts of inventory, which can affect the working capital formula. Significant adjustments relating to inventory can signal improper operational or accounting techniques employed by a company.
Inventory is a liquid asset (hence it being included in the current asset group) in accounting terms. Companies can usually sell this inventory fairly quickly in order to pay bills and increase cash to pay other operating bills. Most companies use accounts payable to pay for new inventory purchases. Therefore, inventory affects working capital on both sides: asset and liability. Companies are typically unable to purchase large amounts of inventory in order to improve their working capital position. This metric ensures the company cannot mislead business stakeholders through simple transactions.
When reviewing inventory and working capital, it is important to keep in mind that some companies can have multiple types of inventory. Manufacturing and production companies can have raw materials, work in process (partially finished) goods and finished goods inventory. For financial accounting purposes, only finished goods are reported on the financial statement. This results in a somewhat uniform calculation for working capital. Management accounting, however, relies on all internal financial information for measuring working capital, which would include all types of inventory maintained in the company.
The relationship between inventory and working capital also deepens when reviewing the inventory for type and condition of goods. Companies that maintain inventory records for long periods of time can often improve their working capital figure. Purchasing inventory using accounts payable typically requires companies to pay for the items in 30 days or less. Retaining the inventory past its final obsolescence date can result in decreasing accounts receivable and higher current assets, creating higher working capital. This allows the company to present a stronger picture for liquidity in operations through manipulating working capital and inventory.
To combat the manipulation of inventory and working capital, business stakeholders can use the quick ratio. The quick ratio formula is current assets minus inventory divided by current liabilities. This financial metric strips away any obsolete or worthless inventory the company still carries on its books. The quick ratio also provides a benchmark figure for comparison against industry leaders. Stakeholders can gauge how well the company performs in its industry using the quick ratio.
