While inventory is an asset officially, it can often feel more like a liability. For example, even though assets such as inventory are defined as "items of economic value", few business owners are excited about having excess inventory. To grasp this asset-liability duality, one must understand the difference between inventory, meaning the products or raw materials themselves, and the cost of holding it.
Inventory is an asset on the balance sheet because it is an item of economic value.
In the field of financial accounting, inventory is defined as the list of products and materials that a business both owns and physically possesses. Inventory on the balance sheet refers to the combined estimated fair market price for each item. However, this figure does not include the price the business paid to acquire the items or the cost to manufacture, maintain or transport those items.
The items held by retailers — finished goods for sale — represent only one type of inventory. Manufacturers and wholesalers have additional inventory classes known as:
- Raw materials such as metal ores, plastics, wood, glass, components and widgets
- Work in process meaning partially completed components
- Raw materials that have been pre-loaded into the supply chain
- Goods for resale, a category that comprises returned or used goods that can be resold
When business owners fret over excess inventory, what they are actually referring to is the cash that went into producing it. For example, to produce a particular item, a business must pay cash for raw materials, electricity for the factory, wages for the laborers and other expenses. In exchange, the business gets a finished product. As long as the business can sell this product for more than the cost of producing it, the company's initial investment will be preserved.
The problem with excess inventory is that the business's cash effectively becomes tied up in goods. Cash is a liquid asset, meaning you can use it immediately to purchase materials and supplies for the business, or to pay expenses. Inventory, on the other hand, is an illiquid asset: You have to sell it in order to raise the cash you need to run the business.
Because a business must pay rent, utilities and payroll with cash every month, holding excess inventory could pose a problem if the inventory is not being converted into cash quickly enough. In the worst case, it could mean either defaulting on payments or being forced to sell finished goods or liquidate inventory at well below cost of production.
The cost of goods for a business's inventory can be claimed as a business expense when filing taxes. This helps protect a portion of the business's revenue (equal to its annual cost of goods) from erosion. In certain situations, the inventory itself can yield tax benefits. For example, a business could donate excess inventory to a Sec. 501(c)(3) or other designated charitable entity and claim it as a tax deduction.