Role of Inventory in Working Capital Homework Help, Tutoring
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Role of Inventory in Working Capital
Inventory
The term inventory refers to the stockpile of the products a firm is offering for
sale and the components that make up the product.
Inventory – Current asset in working capital
It is a part of current asset in working capital calculations. Current assets are
those assets which can be converted into cash easily within a period of one year.
It is assumed that inventory can also be sold and converted into cash within a year's
time and hence categorized as current assets.
Liquidity of Inventory
Though it is categorized as a current asset, practically, they cannot be equivalent
to cash and cash equivalents. In fact, they are not quick assets and hence not included
as cash equivalent in calculating quick ratio or acid-test ratio. The reasons are:
- Although inventory can be sold and converted into cash or accounts receivables, it is a blocked up fund till the accounts receivables are collected.
- The time it takes for the inventory to convert into sales may be longer, sometimes even more than a year. The time depends upon the nature of the product, demand for the product, price and market conditions.
Inventory and working capital
Inventory is treated as a current asset for working capital purposes also. Working
capital is the net of current assets and current liabilities. It is assumed that
inventory can be converted into sales and then to cash/accounts receivables to meet
the current liabilities or obligations.
Inventory and Operating cycle
Operating cycle has the following events:
- Cash converted into inventory
- Inventory converted into accounts receivables
- Accounts receivables converted into cash
- Cash again re-converted into inventory
The above is the case of a normal wholesale or retail business. In case of manufacturing
businesses, the inventory passes through three stages and operating cycle will be
as given below:
- Cash converted into Raw materials
- Raw materials converted into work-in-progress
- Work-in-progress converted into finished goods inventory
- Finished goods inventory converted into accounts receivables
- Accounts receivables converted into cash and
- Cash re-converted into raw materials.
In all the above cases, accounts receivables come into picture in case of credit
sales. In case of cash sales, inventory will be straight-away reconverted into cash.
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