Is Inventory A Current Asset?
The quick answer to this question is yes, inventory is a current asset. Inventory is composed of the products used in the manufacturing of the final product. Why then is it considered an asset? Inventory is classified as an asset in a company’s financial statements because it is used to create the products sold to generate revenue.
In this article, we explain why inventory is a current asset, other examples of current assets, and how inventory differs from other assets. We will also determine whether it is always considered a current asset.
Current Assets Defined
In simple terms, current assets refer to any assets that can be turned into cash within the next accounting period, typically one year.
This definition is not limited to goods anticipated to sell within the year but includes resources injected into the business. Current assets reflect the ability of a company to settle its short-term debts and finance normal business operations.
It is essential to highlight that only tangible assets are considered current assets. Intangible assets such as goodwill, copyrights, intellectual property, and trademarks are not current assets, regardless of whether they can still provide a company with economic value. Why? Businesses cannot easily convert intangible assets into cash.
There are five main types of current assets, as highlighted below:
1. Short Term Security Investments
Short-term security investments are security investments expected to provide returns in a year. They are purchased or sold through stock exchanges and bond markets. For bonds to classify as current assets, they should have a maturity period of less than a year. Similarly, marketable equities such as shares or stocks should sell within a year to get classified as a current asset.
Cash is perhaps the most common current asset. Money market funds and treasury bills generally referred to as liquid securities- are considered cash equivalents and are current assets, as well as they are readily convertible to cash.
3. Accounts Receivable
These are funds that a company expects to receive from customers who have received goods and services but are yet to pay. For accounts Receivable to be considered a current asset, the expected receipt date has to be within a year.
Simply put, these are funds owed to a company by customers who have purchased goods on credit.
4. Prepaid Expenses
These are funds that a business has spent on goods or services expected to be received in the future. You might be wondering, why would expenses that are not expected to earn the company any money be considered current assets? Well, this is because prepaid expenses free up capital to be used later.
Common prepaid expenses include rent, insurance premiums, and payments to contractors. It is essential to highlight that these advance payments can only be annual to consider current assets. For example, if a business decides to pay five years of rent in advance, only one year’s worth of that advance rent can be considered a current asset.
Inventory anticipated to sell within the year of its production is considered a current asset. Compared to the other current assets, inventory is known to be the least liquid. This is because unlike accounts Receivable, where a customer must pay, or short-term securities, which will mature within the year, inventory must be manufactured and sold to be considered a current asset.
Further, not all inventory can sell within a year. Inventory composed of airplanes or specialized machinery may sit in storage for quite some time before being bought. Fast-moving inventory, also known as fast-moving consumer goods (FMCG), is normally the type of inventory classified as a current asset.
What are Non-Current Assets?
This article would be incomplete if we did not at the very least define non-current assets.
Non-current assets are defined as long-term assets whose benefits will accrue for more than one year. They can be tangible and intangible and include fixed assets such as real estate, plant and machinery, and long-term investments in shares, stocks, and bonds. In non-manufacturing industries, non-current assets comprise things such as trademarks, goodwill, and patents.
What is a Current Ratio?
As indicated earlier, current assets determine a business’s ability to fund its daily operations and pay short-term liabilities. Current ratio, also known as “working capital,” is calculated by dividing the company’s current assets by current liabilities. The figure derived from this calculation then reflects the ability of the company to manage its day-to-day operations.
How Does Inventory Differ From Other Assets?
Inventory is a current special asset and, because of that, differs from other current assets in various aspects as detailed below:
- Ease of Conversion To Cash
In terms of liquidity, inventory is considered as being placed in the middle of the liquidity spectrum. Despite its ability to be converted into cash, inventory is still comparatively less liquid than accounts receivable and short-term investments. That being said, inventory is not always easily sold. This provides a difficulty for businesses when accounting for it because it is not easy to determine where to place it. Due to this aspect, some financial analysts consider inventory as a source of payment and reflect a company’s ability to settle short-term debts, while some do not.
Compared to other assets, the process of valuing a company’s inventory is unique. Ordinarily, assets are valued based on their initial cost, which is often a historical cost. For example, the cost of land recorded on a company’s balance sheet is acquiring the land, regardless of current value. However, inventory is recorded either at a low cost or at the current market price. The implication of this is that a company has to make adjustments to its inventory values accordingly based on the current market assessment. Consequently, these adjustments have the effect of either lowering or raising a company’s profit when recorded.
- It is generated internally
This is perhaps the unique aspect of inventory as an asset; it is the only asset that is internally generated a company can record that. For manufacturing companies, the value of inventory is derived from adding labor costs, raw material costs, and several other overhead costs incurred in producing an end product. Conversely, for non-manufacturing companies, this is not the case. For example, for law firms offering legal services, the firm gradually acquires a steady client list, extremely valuable to the firm. However, even though the firm can derive future benefits from this client list, the generally accepted accounting principles do not permit such assets in a company’s financial books.
Also Read: How to calculate Inventory Turnover Ratio
Is Inventory Always a Current Asset?
No. Inventory is not always a current asset. It has the potential to turn into a liability. Inventory may turn into a liability either due to mismanagement-overstocking or a change in customer demands. For example, if you sock too much of a certain beauty product, then customer demand changes abruptly; you might find yourself stuck with obsolete inventory with no market.
Several disadvantages could arise out of inventory becoming a liability, such as:
- Reduction of Cash Flow
Excess inventory could lead to a shortfall in cash flow. This is because the more money you have tied up in inventory, the less you have to pay for essentials such as rent or transportation expenses. On the other hand, it is economical to buy inventory in bulk for some industries to enhance production. However, this only works if you need the inventory to reduce associated costs, such as storage costs.
- Increased associated costs
The more inventory a company stores, the more money it will spend on the associated costs that accrue, such as storage and preservation costs.
Finding the Balance
The key to ensuring that your inventory does not turn into a liability lies in finding a balance for any business. This means that you have to stock just enough inventory such that you will run out, but not more than you need at any given time. You could also consider ordering products only when you need them, which would mean sourcing for reliable suppliers who will deliver what you need in good time.
Businesses could adopt the lean inventory management approach, which provides for the stocking of only that which you need, no more and no less. This necessitates the need to practice having the right amount of inventory at hand at any given time.
To ensure that your inventory is effectively managed, consider investing in an inventory management software such as EMERGE App. With this software, you need not worry about your stocking needs. You will be provided with detailed analytical reports and prompts, ensuring you always have the right amount of inventory.