Inventory is the moving assets of the business, which helps an entity to earn revenue/profits. Inventory converts into Cash well within the Cash conversion cycle period.
Runners Insight
The Cash Conversion Cycle is the time it takes an entity to convert its working capital investment into Cash through its trading activity.
Inventory is the predominant asset of any entity, which can be either a manufacturing or trading business.
Table of contents
Is Inventory a Current Asset?
The answer is Yes.
Let’s understand the reasons through the definition of the Inventory.
Inventory
- is an asset
- Which is used in production (in the case of Manufacturing business) or
- Sold for earning profits (Retail business)
- Which is readily convertible into Cash within a short period
The above pointers are indicators of being a current asset.
Current assets’ useful life never exceeds 12 months, being a liquid asset.
The other examples of current assets are Cash and Cash equivalents, Debtors, Temporary investments, prepaid expenses, etc.
Better Understanding of Inventory
Want to get a better understanding of this?
Don’t worry, we have covered you.
Let’s learn this concept with a different approach.
There are two asset categories – Current and noncurrent.
If we prove that Inventory isn’t a Noncurrent Asset, it inherently falls under the current asset category.
A non-current asset is the one that provides benefit for more than 12 months.
The best example is office furniture. Business entities purchase such assets to accommodate their business needs but not to trade it off as part of their operations.
How about an example?
ABC Company manufactures smartphones. The company uses advanced technology for the assembly and manufacture of phones.
Smart Phones are Inventory, and Equipment is a noncurrent asset.
What are the classification considerations for spare parts?
The entity needs to maintain its Equipment regularly. This requires the stocking of specific spare parts.
What are Spare Parts?
Spare parts are essential accessories that help ensure the uninterrupted operation of Equipment. Spare parts are similar to filters in water purifiers.
Filters are replaced over time or when the purifier’s functioning becomes defective. The cost of filters is much less than that of water purifiers.
Keeping a stock of those interchangeable items helps ensure the Equipment’s continuous operation.
These spare parts are capital inventory and fall under the category of fixed assets under the noncurrent assets category.
In what ways can mismanaging Inventory affect a company’s Liquidity?
The financial users don’t want to compare the two-period balances to evaluate the entity’s performance. However, current, quick, and inventory turnover ratios are essential in decision-making for internal and external stakeholders.
Let’s understand how Inventory plays a vital role in these ratios.
Current ratio
Inventory is the primary component of the current ratio that helps identify the entity’s Liquidity. The higher the ratio, the better the entity’s financial position. For example, the ratio value of 2 infers that the entity’s current assets are two times the current liability, which means the entity’s asset management practices are sound.
Inventory Turnover ratio
Inventory Turnover is the ratio of the cost of goods sold to the average Inventory.
What are the considerations here?
- These inputs (numerator and denominator) should relate to the same period.
- Average Inventory is the average of the period’s beginning and closing inventory balance.
We can interpret the higher turnover ratio as frequent stock and sales movement. For example, an inventory ratio of 12 and 6 implies the company sells the stock once a month and twice a month, respectively. Thus, a higher ratio indicates that the business operates successfully, as product sales are going well.
Frequently Asked Questions
Is Inventory an asset or expense?
Inventory is one of the most liquid assets in the business. So, we can categorize it as a current asset.
What are the types of inventories?
There are three types of inventories for any manufacturing business: Raw Materials, Work in Progress, and Finished goods. Packing materials are also an ancillary innovatory type, which we frequently note in the business.
Is Inventory a capital or expense?
It’s not capital in nature. Those are typically expected to be consumed in production or sold off within a year. So, their nature is an expense (it hits the statement of profit and loss).
What are the different types of Current Assets?
There isn’t a subcategory of current assets. Every asset’s nature is different, so we name and call assets differently, considering their respective nature. However, the Liquidity of those current assets might vary. Cash tops the liquidity subject for any business.
Businesses can use Cash to readily buy or exchange for other benefits, such as WIFI broadband subscription charges. Let’s understand the next most liquid asset under the current asset category.
Marketable security secures the next spot. Inventory wins over Debtors, Other Accounts Receivable, and Prepaid assets. We will categorize these assets using liquidity terms.
- Cash, Marketable Securities, and Inventory stand at the top of Liquidity compared to other assets.
- Debtors, prepaid expenses, and accounts receivable (other than debtors) fall under the bucket with lesser Liquidity.
What are different examples of Current Assets?
Business functions on a credit basis, and to improve Liquidity, there will be financial incentives for early payers. The best example is ecommerce websites. If we purchase additional units of items (such as office supplies), there will be higher discounts. However, those supplies will not be utilized immediately. So, those will be stocked and used as needed. Hence, we name them as prepaid assets.
Other examples include Inventory, balances due from customers, short-term investments, loans and advances that are repayable in the short term, sweeps in bank deposits, etc.
What are the benefits of treating Inventory as a current asset in financial statements?
We can understand the answer to this in two variants.
The first one is simple. It’s a statutory or regulatory requirement to present the assets expected to convert into Cash within 12 months. Thus, business entities avoid inviting noncompliance or penal charges.
The second one is due to accounting practice and logic. Current assets should house only real-time assets whose benefits will be exhausted within a year.
Further, it also provides transparent financial reporting by presenting proper working capital balance.
Summary Version for – “Is Inventory a Current Asset”
Inventory is the main revenue-generating asset. Considering the stage of production, it is classified into three categories: Raw Materials, Work in Progress, and Finished goods.
Inventory falls under the current asset category due to its shorter liquidity tenure. It’s part of the business ratios that helps explain the financial performance. The names of different current assets correspond with their nature.