Inventory and Cash

Inventory and Cash must be considered together. You can think of inventory as crystallized Cash. If you sell the Inventory, it is converted back to Cash. If demand is below expectations, Cash is converted to Inventory. Since you cannot predict what competitors will do, you cannot predict demand perfectly. (This will be explored further in the Forecasting section of this report.) Therefore, your Cash plus Inventory position is a hedge against two risks — the risk of stocking out, and the risk of building too much inventory.

The $31 million in Current Assets came out of somebody's pocket. Naturally, owners and managers want to know how much was funded from their equity (common stock and retained earnings), and how much from the two relevant debt holders, bankers (current debt) and vendors (accounts payable). Working Capital is the Equity portion that came from owners and managers, and Current Liabilities is the Debt portion.

Equity holders and debt holders have competing interests.

Equity holders would prefer to minimize Working Capital. There are two methods at their disposal — fund Current Assets with debt, or reduce Current Assets.

Let's explore funding Current Assets with debt. Debt holders worry that if they fund too much of the Current Assets, the company might default during difficult times. Debt holders monitor the situation with the Current Ratio.

Current Ratio = Current Assets / Current Liabilities

Where Working Capital looks at the issue from the Equity holder's perspective (how much of my Equity is in use), the Current Ratio is looking at the issue from the Debt holder's perspective. If the Current Ratio is 2.0, for every $2 of Current Assets, you have $1 of Current Liabilities and therefore $1 of Equity invested. If it is 3.0, then for every $3 of Current Assets there is only $1 from Debt holders. The bigger the number, the less the risk faced by Debt holders.

A Current Ratio of 1.0 means Current Assets are entirely funded with Current Liabilities. Bankers and vendors hate to see your Current Ratio at 1.0 because if anything goes wrong, you cannot pay your bills, and this puts them in the awkward position of either giving you more money or letting you go bankrupt. As the Current Ratio rises towards 2.0 they become less worried.