What is Inventory to Working Capital Ratio?
Inventory to working capital ratio is a liquidity ratio that measures the amount of working capital that is tied up in inventory. Working capital is the difference between current assets and current liabilities. It represents the funds that a business needs to run its daily operations. Inventory is one of the current assets that a business holds to sell to customers. However, inventory also requires cash to purchase, store, and maintain. Therefore, inventory to working capital ratio shows how much of the business’s working capital is invested in inventory.
Why is Inventory to Working Capital Ratio Important?
Inventory to working capital ratio is important because it indicates how efficiently a business manages its inventory and cash flow. A high ratio means that a large portion of the working capital is locked in inventory, which reduces the liquidity and flexibility of the business. A high ratio may also imply that the business has excess or obsolete inventory that is hard to sell, or that the business has low inventory turnover. A low ratio means that a small portion of the working capital is allocated to inventory, which increases the liquidity and flexibility of the business. A low ratio may also imply that the business has optimal inventory levels that match the demand, or that the business has high inventory turnover.
How to Calculate Inventory to Working Capital Ratio?
Inventory to working capital ratio is calculated by dividing the inventory value by the working capital value. The formula is as follows:
Working capital is calculated by subtracting current liabilities from current assets. Current assets include cash, accounts receivable, inventory, and other short-term assets that can be converted into cash within one year. Current liabilities include accounts payable, short-term debt, and other short-term obligations that must be paid within one year. The formula for working capital is as follows:
In excel, the formula for inventory to working capital ratio can be written as follows:
=Inventory/(Current_Assets-Current_Liabilities)
How to Interpret Inventory to Working Capital Ratio?
Inventory to working capital ratio is usually expressed as a percentage. It shows the percentage of the working capital that is financed by inventory. For example, if the inventory to working capital ratio is 50%, it means that half of the working capital is tied up in inventory. The interpretation of inventory to working capital ratio depends on the industry and the business context. Generally, a lower ratio is preferable, as it indicates higher liquidity and lower inventory risk. However, a very low ratio may also indicate insufficient inventory or missed sales opportunities. Therefore, it is advisable to compare the ratio with the industry average and the historical trend of the business.
Example of Inventory to Working Capital Ratio
Let’s assume that a company has the following financial data:
| Item | Value |
|---|---|
| Inventory | $500,000 |
| Current Assets | $1,500,000 |
| Current Liabilities | $800,000 |
Using the formula, we can calculate the inventory to working capital ratio as follows:
This means that 83% of the working capital is invested in inventory. This is a high ratio, which suggests that the company has low liquidity and high inventory risk. The company may want to reduce its inventory level or increase its inventory turnover to improve its cash flow and profitability.
In excel, the formula for inventory to working capital ratio can be written as follows:
=Inventory/(Current_Assets-Current_Liabilities)
The result is shown in the table below:
| Item | Value | Formula |
|---|---|---|
| Inventory | $500,000 | =B2 |
| Current Assets | $1,500,000 | =B3 |
| Current Liabilities | $800,000 | =B4 |
| Working Capital | $700,000 | =B3-B4 |
| Inventory to Working Capital Ratio | 0.83 | =B2/B5 |
Other Approaches to Inventory to Working Capital Ratio
There are other approaches to calculate inventory to working capital ratio, depending on how working capital is defined. One alternative approach is to use the net working capital, which is the difference between current assets and current liabilities, excluding inventory. The formula is as follows:
This approach shows the percentage of the net working capital that is financed by inventory. For example, if the inventory to working capital ratio is 100%, it means that the net working capital is equal to the inventory value. This implies that the business has no other current assets or liabilities besides inventory.
Another alternative approach is to use the operating working capital, which is the difference between current assets and current liabilities, excluding cash and short-term debt. The formula is as follows:
This approach shows the percentage of the operating working capital that is financed by inventory. For example, if the inventory to working capital ratio is 50%, it means that half of the operating working capital is tied up in inventory. This reflects the cash cycle of the business, which is the time it takes to convert inventory into cash.
