In this article we will explain what type of asset inventory is and why it's important for your business. Read on to learn more.
Inventory is classified as a current asset. This classification means it's expected to be converted into cash within a year or within an operating cycle of a business, whichever is longer. For businesses that sell products, inventory typically represents a significant portion of their current assets.
Below, we highlight the essential characteristics of inventory as a current asset for businesses:
As a current asset, inventory has a degree of liquidity, though it's not as liquid as cash or cash equivalents. The liquidity of inventory largely depends on the nature of the business and the type of inventory. For instance, perishable goods might need to be sold more rapidly than luxury items.
Valuing inventory is critical for accurate financial reporting. Different methods, such as First-In-First-Out (FIFO) and Last-In-First-Out (LIFO), can be used depending on the company's accounting practices and the jurisdiction's regulations.
Inventory holds a significant position on the balance sheet. Its value can influence metrics like the current ratio, which assesses a company's short-term financial health. Moreover, the cost of goods sold, derived from inventory costs, impacts the profit & loss statement.
Inventory is typically classified as a current asset because it is expected to be sold or consumed within one year or the operating cycle, whichever is longer. However, there are rare and specific situations where inventory might not be considered a current asset:
1. Long Production Cycles: Industries with exceptionally long production cycles can have inventory that isn't sold within a year. In such cases, that portion of inventory might be considered a non-current asset until it's closer to being sold.
2. Specialized Business Models: Some companies invest in items like fine wines or collectibles intending to hold them for long-term appreciation. For these businesses, such items might not be treated as regular, short-term inventory but rather as longer-term assets.
3. Land Held for Development: When a company buys land for future development without the intent to sell or develop it within a year, it's often classified as a non-current asset, despite being similar in nature to inventory.
4. Natural Resource Companies: Firms in sectors like logging, mining, or oil extraction might initially categorize resources as non-current assets. However, once extraction is imminent or underway, these resources can transition to being current assets as they effectively become inventory ready for sale or processing.
These scenarios are exceptional, not standard. For most businesses, inventory remains a current asset due to its short-term utilization or sale expectations.
We hope this article has given you a better understanding of what type of asset inventory is and why it is classified as a current asset.
If you enjoyed this article, you might also like our article on what excess inventory is or our article on inventory analysis.
