Inventory includes raw materials, work in progress, finished goods, and products purchased for resale. Because businesses use inventory to generate revenue, it’s classified as an asset. But is inventory a current asset or a non-current asset?
The short answer is inventory is almost always a current asset. This article explains why inventory appears as a current asset on a company’s balance sheet and why it matters.
What Are Current Assets?
Current assets are assets a business plans to use, replace, or convert to cash within a normal operating cycle–typically less than 12 months.
Current assets are typically presented first on the balance sheet and arranged in order of their liquidity, or the order in which the company expects to turn them into cash.
Cash and cash equivalents are the most liquid assets. Other examples of current assets include:
- Short-term investments
- Accounts receivable
- Prepaid expenses
- …and inventory
What Makes Inventory a Current Asset?
Business owners typically don’t produce or purchase inventory unless they believe they will be able to sell it within one year. If the company expects to sell it within a year of the balance sheet date, the inventory is a current asset (or short-term asset) on its financial statements.
What Are Non-Current Assets?
Non-current assets typically take longer than one operating cycle to be converted into cash. Examples of long-term assets include:
- Marketable securities
- Property, plant, equipment, and other fixed assets
- Intangible assets such as copyrights, patents, and trademarks
- Long-term investments
- Notes receivable with a due date more than one year in the future
In rare cases, a small business may have inventory that it expects to sell after one year. In that case, inventory can be a non-current asset. However, the company should have a good business reason for holding inventory that it doesn’t expect to sell within the next accounting period.
Otherwise, unsold inventory might be more accurately included in liabilities due to the costs to continue storing, insuring, and maintaining it. The longer inventory sits around, the greater the risk of:
- Spoilage: Inventory the company has to throw away due to rot or decay (common in restaurants and other businesses that carry inventory with a short shelf life)
- Shrinkage: Goods that are lost, damaged, or stolen before the business can sell them
- Obsolescence: Dead stock that the company can’t sell due to lack of demand
It’s also not profitable for companies to tie up cash flow in unsold excess inventory.
Is Inventory an Expense?
Your business spends money on inventory, so you may wonder why you can’t simply record purchases of inventory as an expense.
You don’t write off the cost of inventory due to the matching principle. In accounting, the matching principle requires businesses to record expenses in the same accounting period in which those expenses help generate revenues.
For example, say you purchase $50,000 of inventory in December of 2023, but don’t sell it until January 2024. If you write off that $50,000 as an expense in 2023, two things happen:
- Your total assets will be understated by $50,000 because the inventory won’t be included on your balance sheet
- Your expenses will be overstated by $50,000 without any corresponding revenue.
Now say you’re applying for a loan and you give the bank your 2023 financial statements. That understatement of assets and overstatement of expenses might make it look like your business isn’t profitable. The bank might even decline your loan application, so make sure you only include inventory when you sell it—at that point, it becomes a cost of goods sold.
How Does Including Inventory in Current Assets Impact a Company?
Including inventory in current assets on a company’s balance sheet impacts several important financial metrics and key performance indicators, such as:
Lenders and investors use the current ratio to analyze a company‘s liquidity position in the short term.
Current Ratio = Current Assets / Current Liabilities
Ideally, a small business has a current ratio of 1:1. If its current ratio goes below 1, it might signal that the company is struggling financially and may not have enough short-term assets to cover its short-term debts.
Including inventory in your current assets (rather than as a non-current asset or expense) helps keep your current ratio in an acceptable range. Why? Because it essentially adds to your assets, and the more assets you have, the more likely you are to be in the black.
Inventory turnover measures the number of times a small business sells its inventory during a given period.
Inventory Turnover = Cost of Goods Sold / Average Inventory
Generally, a high inventory turnover ratio indicates strong sales and a low inventory turnover ratio indicates weak sales or decreasing market demand for the products. However, a good inventory turnover ratio depends on the industry and type of inventory carried. High-end goods tend to have low inventory turnover. For example, a luxury auto dealer’s inventory turnover ratio will be much lower than an office supply store.
Working capital is a popular metric for determining whether a company has enough current assets on hand to cover short-term expenses and debts.
Working Capital = Current Assets - Current Liabilities
A positive number means the business has enough cash to cover its immediate needs. A negative number might mean it’s struggling to make ends meet. Including inventory in your current assets improves your working capital, which might make your business more attractive to lenders or investors.
How Does a Small Business Calculate the Value of Unsold Inventory at Year End?
Inventory usually accounts for a large portion of a business’s assets, so its inventory valuation method can significantly impact a company’s profits, financial statements, and the amount of income tax it owes.
There are several ways to value inventory:
- First In, First Out (FIFO): The FIFO method assumes that the first item purchased will also be the first used or sold (i.e., the oldest ones on the shelf are the first to go). This is the most common inventory valuation method for small businesses because companies typically sell or use products in the order they purchase them. So FIFO best represents the actual flow of goods in a business.
- Last In, First Out (LIFO): The LIFO method assumes that the last items purchased will be the first ones sold or used (i.e., the newest items you bought are the first to sell). Only companies in the U.S. use the LIFO method—it’s allowed by U.S. generally accepted accounting principles (GAAP) but not by International Financial Reporting Standards (IFRS).
- Average Cost Method: To account for inventory using this method, a company divides the total cost of merchandise purchased or produced during the accounting period by the total number of items bought or manufactured. The value of any remaining inventory is based on that calculation. Companies that don’t have much variation in their inventory might use the average cost method.
- Specific Identification Method: Every individual unit of inventory is tracked from the time it’s purchased until it’s sold. This method is typically used by companies that sell very high-ticket products, such as vehicles, antiques, or works of art.
It’s essential to keep in mind that inventory valuation is an accounting decision—it’s not necessarily related to the way a company uses inventory in its business operations.
For example, a company might use the LIFO method because it helps lower their taxable income. As prices rise each year, the business can write off higher priced goods to lower its taxable income. But that doesn’t necessarily mean it needs to move the newest inventory first.
Inventory Management Best Practices
Properly managing your inventory can help you keep inventory moving and avoid losing it to spoilage, shrinkage, and obsolescence. Here are a few general inventory best practice to consider:
1. Prioritize Your Inventory
Categorize your inventory into three groups:
- Items that have high value but are small in number
- Items that are moderate in value and number
- Items that have low value and are large in number
Organizing your inventory into these three categories can help you know which items to keep an eye on. For example, you probably want to make sure you have more high-value items coming in if you’re on the low side. Meanwhile, if you have a ton of low-value items, you can probably wait on that order.
2. Do Regular Inventory Counts
At a minimum, you should count all of your inventory once a year to ensure the actual inventory on hand matches what’s in your records. For higher-value items, you might want to count inventory more frequently. This helps you spot potential problems—such as inventory that’s being mishandled or stolen—before it costs the business too much money.
3. Use Inventory Management Technology
A very small business might be able to manage inventory in a spreadsheet. But larger businesses can benefit from technology. A good inventory management solution can help you track sales and determine when to reorder. Look for one that integrates with your point-of-sale system or accounting software.
Let’s Wrap It Up: Make Your Inventory a Current Asset
Ordering the right amount of inventory is key to ensuring that your inventory is an asset rather than a liability. An inventory management system can help you determine how much stock to keep on hand so you don’t run out without storing more inventory than you need.
When you find that balance, your inventory can be sold quickly and converted into cash, which you can reinvest into your business for continued growth. And that is why inventory is—and should be—a current asset.