Inventory to working capital ratio

Inventory to working capital ratio

  • Inventory to WC ratio allows investors to calculate the exact portion of the working capital of the business that is tied up in its inventory
  • By inventory to WC ratio, we find out how much percentage of working capital stuck in the inventory

Formula

Inventory to WC ratio is the ratio of Inventory and working capital

Inventory to WC ratio = Inventory / Working capital

Working capital = Current assets – Current liabilities

Like in the previous blog of his liquidity, the difference between current assets and current liabilities is called working capital, this formula will not be used here because here it is talking about the current assets used in the cycle of working capital.
The working capital cycle consists of only account receivables and inventory as current assets and only account payables as current liabilities.

Inventory to working capital ratio

Working capital = (Account receivable + Inventory) – Account payble

Inventory to Working capital ratio = Inventory / [(Account receivable + inventory) – Account payable]

This ratio is usually interpreted in terms of percentage. In this way, it gives a more realistic picture of the liquidity position of the company.

Inventory to Working Capital Ratio Example

Let us calculate the inventory to net working capital ratio of BHEL company. Their data of 3 years of current assets and current liabilities are written below.

Company dataMarch, 2018March, 2019March, 2020
Inventory6,258.76 cr.8,113.49 cr.8,905.46 cr.
Account receivable22,771.49 cr.12,009.57 cr.7,107.62 cr.
Account payable10,586.86 cr.11,375.11 cr.8,891.98 cr.

You can find this data on the balance sheet of any Indian company on the website https://www.moneycontrol.com/

First of all, you have to go to the https://www.moneycotrol.com website, after that you will have to search by entering the name of the company and you will have to click on the option of financial data upwards. you will get an option of a balance sheet as soon as you click. On which you can find this data by clicking.

Use the information in the table above to calculate the company’s inventory to working capital ratio in percentage. Now let’s break it down and identify the values of different variables in the problem for each year

Let’s calculate the inventory to working capital ratio for each year.

For 2018

Working capital = (Inventory 6258.76+ Account receivable 22771.49) – Account payable 10586.86 = 18443.39

Inventory to working capital ratio = Inventory 6358.76 / Working capital = 18443.39 = 0.3447 = 34%

Similarly 2019

Working capital = (8113.49 + 12,009.57) – 11,375.11 = 8747.95

Inventory to WC ratio = 8,113.49 / 8747.95 = 0.9274 = 92%

Similarly 2020

Working capital = (8,905.46 + 7,107.62) – 8,891.98 = 7121.1

Inventory to WC ratio = 8905.46 / 7121.1 = 1.25 = 125%

This example shows that the company’s increasing trend over time depends on how its operations depend on inventory, which is very dangerous. With time it will be challenging for the company to turn over its inventories to make payments to its short term liabilities and accounts payable. 

Inventory to working capital ratio analysis

A high Inventory to WC ratio means that almost nearly all the working capital is tied up in inventory which is very dangerous if it is not sold. Too much inventory in stock attracts storage and maintenance costs, which in turn reduces the company’s profit.

In general, an increasing inventory to working capital means that the company is facing an operational problem, which may result in difficulties in paying short-term liabilities and clearing accounts payable.

A low inventory, working capital ratio means that the company can liquidate its inventory fairly quickly and be able to meet its short-term liabilities.

  • If the inventory to working capital ratio of a company is less than 50%, then the company is considered to be in a very good liquidity position and this means that the company will meet its short-term liabilities comfortably. Investors may consider investing in companies of this type
  • If the inventory to working capital ratio of a company is above 50% but below 100%, then one should wait to invest in companies of this type Too much inventory in stock attracts storage and maintenance costs, which in turn reduces the company’s profit.
  • If the Inventory to working capital ratio of a company is above 100%, then it means that the total working capital of the company is trapped in the inventory of the company which is not a good sign for any company. This type of company not able to pay its short-term liabilities, Investing in such company means losing money

Remark

By calculating the inventory to working capital ratio of BHEL company above, we find that the inventory of BHEL company is increasing every year, which means that most of the working capital of the company is trapped in the inventory of the company, which is not a good sign for the company. Do not invest in companies of this type.

If you do not know the basic of liquidity ratio, then you can read the first post of liquidity ratio. Read now

Thanks for reading this post, God bless you all

Leave a Comment