Typically speaking, our finances are split into three distinct categories, assets, equity, and liabilities, with assets and equity bringing value, and liabilities subtracting value from our net worth, but sometimes the line between assets and liabilities gets a little hazy. For example, is inventory an asset or liability?
Inventory is defined as any of the raw materials used in production processes, or the finished items that are for sale in an outlet. On the one hand, as the owner of the business, you likely own the related inventory, which would suggest it’s an asset, but there are a few scenarios in which the opposite could be considered true — Inventory is sort of the Schrödinger’s Cat of accounting.
So, is your inventory an asset or a liability? Well, it all comes down to specifics. In certain circumstances, it might be classed as a liability from the get-go, whilst in others, it may begin as one and become the other. Allow me to elaborate…
Is Inventory An Asset Or Liability?
When Is Inventory Considered An Asset?
Most of the time, the inventory of a well-run business will be an asset, as it’s an easily liquidated resource that promises future economic benefits. See, inventory orders are largely based on data regarding the demand for certain goods, meaning there’s historical precedent for the inventory’s sale at a higher price than the business purchased or made it for.
Seeing as the inventory will directly lead to wealth accumulation, by definition, it cannot be considered a liability, as liabilities are financial deficits and debt. However, despite our best forecasting, we don’t always get inventory right.
When Is Inventory Considered A Liability?
In an ideal world, all businesses would be left with completely bare shelves and stockrooms each time they place orders for new inventory, but this is rarely the case, as buyers can be a fickle bunch, and it’s impossible to truly know what’s going to sell.
Client demand is a constantly shifting phenomenon, and sometimes it can change on a dime, leaving billions of items across the United States unsold. And when inventory doesn’t sell, it can become a problem!
The longer a business holds on to stock, the greater the chance that it will take on some form of damage, thereby reducing its value, or in severe cases of deterioration, rendering it completely valueless.
Granted, even if the blemished inventory in question is sold at a discount price for a profit, it’s still technically an asset, but if sold below the initial acquisition cost, or worse yet, trashed, it has become a liability.
This is why it’s essential that you look after your inventory as best you can by storing and displaying it appropriately. For any business dealing with perishables, stock deterioration is a big concern, but significant mark-ups can help hedge against losses when food goes unsold.
Without proper planning, unsold inventory can really start to stack up and hog valuable space, and in business, space rarely comes free. Unless you own a storage facility, you may end up forking out a small fortune to house your stagnant inventory, and even if you do own a facility, space taken up by these pieces that you can’t shift could be used in a more profitable manner.
This dip in efficiency can wind up taking a pretty hefty toll on revenue, which is why most businesses will do whatever they can to get rid of residual stock. This is why you’ll see designer outlet stores selling excess inventory at reduced rates.
Any way you slice it, immovable stock always becomes a liability in the end, unless, that is, you hold on to it for so long that its value appreciates significantly, but that would be a very rare turn of events, and holding on to stock is generally seen as a bad thing.
Reduced Working Capital
All inventory is an investment, and when it doesn’t sell, the funds invested stay exactly where they are, reducing your working capital in the present and stunting business growth. Every single order placed, no matter how small, is a gamble that you’re hoping will pay off, but sadly, this isn’t always the case.
Frequently Asked Questions
How Do You Limit Accumulation Of Stagnant Inventory?
Unfortunately, there is no easy resolution to this quandary. The only way to minimize losses on inventory is to learn the industry and constantly analyze demand. With some experience under your belt, ordering approximately correct inventory will become second nature.
What If You Purchased Inventory With Borrowed Funds?
Any unfulfilled debt is considered a liability, so what does that mean for inventory purchased using a loan or credit of some description? Well, even if the working capital used to acquire inventory is borrowed, the inventory starts out as an asset, as it has the potential to cover your debts and then some.
The debt still exists, so it can’t be disregarded, but it is its own liability, one likely resolved when the corresponding stock sells, but what if it doesn’t sell for a while and due to stock deterioration or storage fees, the business only breaks even?
In this scenario, even though no money has been lost, and the debt has been paid, the inventory in question could be considered a liability as the time and effort put into making it profitable has been wasted. These resources could just as well have been directed towards different inventories that might have flown off the shelves.
If you’re wondering what inventory will look like on your balance sheet, it’s always going to land in the assets section — Hooray! But, as you now know, what looks good on paper isn’t always a positive thing in practice.
As time goes on and products don’t sell, their mere existence is costing you money, be it due to deterioration, storage costs, or stunted growth. The longer they stay on the shelves, their liquidity decreases, which is why a good old-fashioned clearance sale is such a common tactic. An event like this wipes the slate clean, allowing the business to cater to new demands and maximize profits.
Paul Martinez is the founder of EcomSidekick.com. He is an expert in the areas of finance, real estate, eCommerce, traffic and conversion.
Join him on EcomSidekick.com to learn how to improve your financial life and excel in these areas. Before starting this media site, Paul built from scratch and managed two multi-million dollar companies. One in the real estate sector and one in the eCommerce sector.