by The amount of current assets that a company has on hand at any given time, in excess of its current liabilities, is known as its net working capital (NWC).
These funds are what allow a business to run its daily operations. One of the short-term assets held by many companies is the cash invested in its inventory. But if this inventory amount is relatively large compared to other assets, it can skew the perception of just how readily available a firm’s cash truly is for paying off short-term debts. Sometimes a company’s inventory can suffer from extremely low turn-over, or simply becomes outdated and difficult to sell.
The inventory to net working capital ratio allows you to calculate exactly what proportion of a business’s working capital is tied up in its inventory, giving you a more accurate picture of its liquidity position.
Stock (Inventory) to Working capital Ratio = Inventory / (Accounts Receivables+ inventory – Accounts Payable)
Cautions & Further Explanation
Analyzing a company’s inventory to net working capital ratio is best done over a number of periods to accurately identify trends in the use of a firm’s working capital.
Such trends can help to reveal any problems in a company’s regular operations, including the rising ratio values associated with heavy quantities of outdated stock, inferior purchasing control, and inefficient sales forecasts.
Ideally, you should use the inventory to NWC ratio at the same time as you examine a company’s inventory turnover rate, since stock that consistently turns over quickly will contribute far more positively to an organization’s level of liquidity.
Interpretation & Analysis
In general, the lower a company’s inventory to working capital ratio is, the higher its liquidity.
This will be particularly true for those businesses that hold large quantities of inventory and that require certain levels of cash to fund their operations.
While some analysts consider ratio values of less than 100% to be sufficient proof of a company’s liquidity, this value often proves to be too generic for every situation.
Inventory to WC ratios vary widely between industries and companies, and you’ll glean more meaningful information by using industry averages as a benchmark in your analyses.
