How does inventory affect working capital?

Working capital and inventory have a symbiotic relationship in a business, meaning each component affects the other. This means you can optimise your working capital by examining your inventory management and making some adjustments.

This guide will explain how inventory and working capital work together in a small business. We’ll answer the following questions:

• What is working capital?
• What is inventory?
• How does inventory affect working capital?
• What is the inventory to working capital ratio?
• How can optimising inventory boost working capital?

Working capital measures a business’ ability to pay its short-term obligations (current liabilities) with assets it has on hand (current assets). The working capital formula is: 

Current assets – current liabilities = working capital

The higher your total is when using this formula, the more capable you are of paying your dues with what you have, which indicates that your business is financially healthy. 

Although, how high your working capital number is depends on the value of your assets and liabilities. For example, even if you have many valuable assets, you might still have a small working capital if your liabilities are equally high. On the flip side, if you don’t have many assets, but your liabilities are minor, you may have more working capital available.

Inventory is a current asset, which is why it can affect the working capital formula. We’ll get into that later, but let’s first look at what inventory is. 

Inventory refers to products a business owns and plans to use in its production process within the next year, including raw materials, work in progress, or finished goods. 

Keeping inventory can be costly depending on where and how you need to store it. For example, storing your inventory in a warehouse with refrigeration facilities costs more than keeping it on a shelf in your home. 

The amount of inventory you store also has a direct impact on your income. Having too much inventory means you might end up spending more on it than you make. If the inventory becomes spoiled and you can’t sell it, you’ll have wasted the money you spent on it. 

Conversely, not having enough inventory means you could lose out on sales because the product is out of stock. The key is to find a balance.

Since inventory is a current asset (meaning you plan to sell it within the next year), it plays a crucial role in determining your working capital. For some companies, such as a small craft business or cupcake bakery, inventory could represent a substantial part of current assets. For other companies, like a dog walking business, inventory will take up only a small portion. 

Your working capital can fluctuate a lot year-to-year if you under- or overestimate demand for your products. In addition, if you use just-in-time (JIT) inventory management where you keep as little inventory on hand as possible, it’ll have a smaller impact on your working capital. 

The inventory to working capital ratio is a formula you can use to calculate your operational efficiency. You calculate it by dividing inventory by working capital. See below:

Inventory ÷ working capital = inventory to working capital ratio

For example, if your company has £10,000 in working capital and £8,000 in inventory, the calculation would be:

8,000 ÷ 10,000 = 0.8

This means that £0.8 of every pound of working capital is tied up in inventory. 

If you get a value of one or less, it could indicate high liquidity in current assets, meaning you can easily convert it into cash within a short amount of time. A low inventory to working capital ratio could also mean that you don’t have enough inventory to meet product demand. On the other hand, a high inventory to working capital ratio could mean you have too much inventory, which can increase storage costs and wastage. 

Calculating this ratio can help you understand how much of your working capital is tied up in inventory and how much cash you can generate from your operation.

Optimising your inventory can help you do the same with your working capital. Since you need healthy working capital to succeed, you need to make sure your inventory helps you achieve it. If your inventory management prevents you from meeting your financial obligations, you stifle your growth and put your entire business’ survival at risk.

That’s why examining your inventory management and making some adjustments can help you increase your working capital. An excellent way to do this is to calculate your inventory turnover rate, meaning how often you sell and restock your inventory during a set period. Learn more about calculating inventory turnover.

You can also look at how much you currently spend on your inventory, including raw materials, storage, production, and so on. Perhaps you can negotiate a cheaper price with your suppliers or find a more cost-effective method for storing your goods? 

The more of your current assets your inventory holds, the more you can improve your working capital by making smart adjustments to your inventory management. Learn more about inventory management here.

Small businesses tend to have less leeway with their working capital, and how they can approach their inventory management, so you need to be savvy with your investments.

Optimising your working capital through inventory management is a great way to create the framework you need to succeed. Since both are part of financial management, you need the right tools to help you manage it more efficiently.

Countingup is the business current account with built-in accounting software that allows you to manage all your financial data in one place. Features like automatic expense categorisation, invoicing on the go, receipt capture tools, tax estimates, profit and loss statements, and cash flow insights help you run your business more effectively.  

You can also share your bookkeeping with your accountant instantly without worrying about duplication errors, data lags or inaccuracies. Seamless, simple, and straightforward! 
Find out more here.