In our last article we have discussed about inventory turnover ratio to know how effectively the company is managing its stock of goods to make money. In this article we will show you how to compare inventory to net working capital.
In current assets, inventory is considered as the least liquid asset even though company makes money by selling it to customers. To know how much funds are tied up in raw materials, WIP and finished goods, you can calculate inventory to net working capital ratio.
Before calculating this ratio, you should know what is inventory and how to calculate net working capital.
Inventory for a company includes followings:
- Raw material
- Work-in-progress (WIP)
- Finished goods
You can get the total closing balance of raw materials, WIP and finished goods from company’s balance sheet.
Net working capital (NWC) of a company is calculated by taking out current liabilities from current assets. Therefore, the formula to calculate NWC is;
NWC = current assets – current liabilities
It shows the liquidity position of a company as on the balance sheet date. It tells you whether the company can meet its short term obligations or not.
If the company has more short term obligations in comparison to its current assets, then you will have negative NWC. It means company requires short term funding to run its business.
Formula to calculate inventory to net working capital ratio and its analysis
Here is the formula to calculate the ratio:-
Inventory / NWC.
If the ratio is high compared to Industry average, then it means the business has too much invested in raw materials, WIP and finished goods in comparison to its net working capital. If its low, then business has more liquid assets and stock of goods is a small part of it.
Inventory to net working capital is a better financial tool to assess financial health of a retail and manufacturing organization. If the company can run its business with low investment in raw material, WIP and finished goods, then a low ratio is better.
