Inventory to Working Capital Ratio

Definition

The term inventory to working capital ratio refers to a calculation that allows an investor-analyst to understand the ability of a company to raise additional cash from working capital. This metric is used in conjunction with other metrics like inventory turnover.

Calculation

Inventory to Work Capital Ratio = Inventory / Working Capital

Where:

  • Working capital is defined as accounts receivable plus inventory minus accounts payable.

Explanation

Liquidity measures allow the investor-analyst to understand the company's long term viability in terms of fiscal health. This is usually assessed by examining balance sheet items such as accounts receivable, use of inventory, accounts payable, and short-term liabilities. One of the ways to understand how much cash can be raise using working capital is by calculating the inventory to working capital ratio.

Calculating the inventory to working capital ratio allows a company's finance team, or investor-analyst, to understand how much cash can be raised by the company using its working capital. For example, if a company has a relatively large ratio, it may be harder to convert working capital into cash. This is especially true if the company's inventory turnover ratio is also relatively small, which may indicate too much cash is tied up in inventory. When possible, the investor-analyst should benchmark the target company against its competitors. In the same way, the ratio should be evaluated versus other inventory metrics.

Example

The manager of a large mutual fund would like to understand how easy it is for Company ABC to raise capital from working. He asked his analytical team to calculate Company ABC's inventory to working capital ratio. The team had already benchmarked Company ABC's inventory turnover ratio (5.2), which was below the industry average of 6.0. The manager's team extracted the information below from the most recent SEC filings.

  Prior Year Current Year
Ending Inventory $19,052,000 $28,578,000
Accounts Receivable $36,600,000 $54,900,000
Accounts Payable ($14,640,000) ($19,215,000)
Working Capital $41,012,000 $64,263,000
Inventory to Working Capital Ratio 0.46 0.44

The analysis revealed Company ABC also had a relatively high proportion of working capital tied up in inventory. Based on this information, coupled with the relatively low inventory turnover value, the mutual fund manager decided to take a closer look at a number of other liquidity metrics for Company ABC before making an investment decision.

Related Terms

liquidity index, accounts payable turnover, accounts payable days