Inventory to working capital ratio is defined as a method to show what portion of a company’s inventories is financed from its available cash. This is essential to businesses which hold inventory and survive on cash supplies. In general, the lower the ratio, the higher the liquidity of a company is. However, the value of inventory to working capital ratio varies from industry and company. In conclusion, the better benchmark is to compare with the industry average.
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To better explain inventory to working capital, it is an important indicator of a company’s operation efficiency. Note that a low value of 1 or less of inventory to working capital means that a company has high liquidity of current asset. While it may also mean insufficient inventories, high value inventory to working capital ratio means that a company is carrying too much inventory in stock. Because excessive inventories can place a heavy burden on the cash resources of a company, it is not favorable for management. A key issue for a company to improve its operation efficiency is to identify the optimum inventory levels and thus minimize the cost tied up in inventories.
Working capital = 8,000 / 10,000 = 0.8
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For example, John owns a business which manufactures electronic prototypes. He has been an electrical engineer for years and knows the operations of his business. But over time, John realized that he needs to know more about the financials of his business. Because he hopes to retire one day, he is becoming more serious about his personal financial welfare.
Recently, John has been familiarizing himself with his quickbooks. Now, John wants to perform inventory to working capital analysis. He collects necessary information and performs the following calculation:
Working Capital = $8,000 / $10,000 = 0.8
Although John is satisfied with this ratio, like any business owner, he would like to decrease inventory supplies. Now that John knows where he stands, completing this task can be simplified.
After some research, John is able to find a local supplier of many of his inventory items. Though slightly more expensive, John begins to use this vendor. He can increase his payout and put more money into his personal retirement account when he has decreased inventory . John sees the value of keeping track of his company finances, and vows to regularly update his records. For more ways to improve your cash flow, download the free 25 Ways to Improve Cash Flow whitepaper.
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