Inventory and working capital: is inventory an investment for a business?

In the case of a working capital shortage in a business, inventory is one of the first things that managers consider. And the first question usually is “How much inventory can we cut?”

However, it is a question about the money that has been previously invested into inventory and the chance to free up some of it. Indeed, inventory is not a storage cost nor a balance sheet entry. It is money that is deliberately invested into the supply chain in order for the company to be able to make sales, deliver services, and provide production or supply continuity.

Selling an item sitting on the shelf secures income. Availability of key components avoids production interruption. Seasonal inventory created in advance allows meeting demand prior to its replenishment by suppliers.

At the same time, inventory uses the company’s money until it is sold, consumed, returned, or written off. Inventory that no longer has a clear connection to actual sales, customer service, or production needs can limit the company’s ability to pay suppliers, invest in growth, ensure the availability of critical products, or respond to changes in demand.

The objective, therefore, is not to reduce inventory at any cost. The objective is to manage inventory as an investment: to hold enough stock to protect the flow of the most important products, but not more than current demand and real supply conditions require. This is where inventory management and working-capital management come together.

Why is inventory a working-capital issue?

In financial statements, inventory is generally reported as a current asset. It is usually measured at the lower of cost and net realizable value. If products are damaged, obsolete, partially obsolete, or expected to be sold for less than their cost, the value of the inventory must be written down. This is the accounting perspective.

From a management perspective, however, every product, raw material, part, or component held in a warehouse represents money the company has already spent, even though revenue from selling or using that item has not yet been received.

This capital creates value when it:

• ensures the availability of in-demand products;
• helps maintain service levels for important customers;
• reduces the risk of lost sales;
• protects production from downtime;
• helps prepare for seasonality, promotions, contracts, or major customer projects;
• enables the business to respond reliably to demand.

Inventory therefore has two functions. In accounting, it is an asset; operationally, it is an investment in product availability and flow.

However, the capital invested in inventories is directly related to liquidity as well. According to the KPMG study on more than 2,700 public U.S. companies, the average inventory-days ratio increased from 73 days in 2020 to 80 days in 2024. In the meantime, the cash conversion cycle equaled 89 days in 2024. Thus, the capital invested by the company in inventory becomes locked for a longer time, with higher levels of inventory being one of the factors responsible for it.

As noted by PwC, inventory is a “silent absorber of uncertainty.” To ensure their protection from potential supply chain interruptions, businesses raise the amount of stock; however, in this case, the level of liquidity may decrease together with higher expenses for storage and higher risks of obsolescence. It is also noted by PwC that in 2024, in capital-intensive industries, the average days inventory outstanding were 90.2 days in the European Union, 68.6 days in North America, and 62.8 days in the UK.

Therefore, when discussing inventory and the money invested in it, the key question is not, “How much inventory should we reduce overall?” The more important question is which inventory protects sales and production flow, and where capital no longer creates sufficient value.

When does inventory create value?

The value of the inventory lies in its functionality within the business process. A product stored in the right place, at the right time, and in the right amount could lead to making the deal which might have been missed otherwise. A critical part would save the production process from coming to a halt, whereas an excess of seasonal inventory could cater to the demands during a shortage.

In the same way, there is a dynamic relationship between products. For instance, a fast-moving product will start to sell at a slower pace. In addition, a seasonal product becomes excess inventory once the season has passed. Where the supplier delivers more frequently, the local stock requirements may reduce. One product may be required in one warehouse but not in another.

For this reason, inventory investments need to be reviewed regularly, not only when the company is already experiencing a cash-flow problem.

When does inventory stop creating value?

Inventory requires attention when it remains in the warehouse but no longer serves a clear commercial or operational purpose. This can happen when:

• demand declines or shifts to another product;
• the item was purchased for a promotion, season, project, or tender that has already ended;
• inventory was bought to meet a supplier’s minimum order quantity, obtain a discount, fill a pallet, or meet a transportation threshold;
• the product is held at a location with low demand, while it is needed elsewhere;
• assumptions about lead times no longer reflect the supplier’s actual performance;
• replenishment parameters were set in the past and have not been reviewed for a long time;
• the product is being replaced, discontinued, or becoming obsolete;
• safety stock for the same demand stream is held at several points in the supply chain.

In these situations, inventory continues to tie up company funds while contributing less and less to product availability, sales, or production flow.

It is necessary to notice these situations on time, when there are still many options available for the company. It can decrease or terminate future deliveries, move the product to another place, have a clearance sale, change prices, develop bundles of products, negotiate the return with the supplier, and conduct a product discontinuation process.

Why is a general inventory reduction not a good approach?

A general inventory reduction target could be a good financial indicator because it reflects how much capital is occupied by the inventory at the moment. However, the target itself does not tell which positions need to be reduced.

Reducing the inventory levels of all products proportionally means that the company will lose the opportunity to have enough supply of the most important, the fastest moving, or the highest revenue products. This will cause problems such as lost sales, customers’ dissatisfaction, urgent purchases from suppliers, higher costs of transportation, delays in production, and additional work for the purchasing and sales departments.

However, the decision to reduce excess inventories is rarely implemented quickly. Reducing future orders does not mean that excess products will be quickly sold from the warehouse. Additional actions are required: transfer, clearance sale, price change, kitting, return to supplier, or discontinuation.

The opposite situation is also possible: a company may have a high total inventory value while constantly facing shortages of its most important products. In this case, the issue is not only the overall amount of inventory, but also its poor allocation across SKUs, locations, and the wrong products.

Inventory management is therefore a balance between customer service, cost, and working capital. Some critical products require a greater investment in availability. For others, excess stock only reduces liquidity and increases the risks of storage costs, obsolescence, and write-offs.

Inventory is more than one number

Management often sees the total value of inventory and asks whether it is too high. But this question is too broad to support a precise decision.

A company may have an overall inventory value that appears acceptable at first glance, while its inventory structure is still unsuitable:

• too much inventory is held in slow-moving SKUs;
• too little inventory is available for fast-selling or strategically important products;
• one location holds excess stock while another experiences shortages;
• high inventory volumes were created by supplier requirements rather than actual consumption;
• safety stock for the same need is held at several points in the supply chain.

For this reason, inventory should be assessed at SKU and location level. Only then is it possible to understand exactly where money is tied up, what function a particular inventory position serves, and which action is most appropriate.

When assessing inventory, it is useful to monitor not only its total value but also:

• inventory turnover or days of inventory on hand;
• availability of the most important products;
• stockout incidents and lost sales;
• fast-moving, slow-moving, and non-moving products;
• lead-time and delivery reliability;
• the product’s importance to the business;
• inventory value by SKU and location;
• the risk of write-offs and obsolescence.

How does StockM help make this practical?

Our experience working with clients shows that most companies want to reduce inventory. In many cases, they even know how much of their inventory is non-moving or slow-moving. However, this information alone is not enough to manage inventory effectively.

The main challenge is usually not identifying that there is too much inventory. The harder part is understanding:

• which specific products and locations are creating the problem;
• which products are most important for sales and availability;
• whether excess inventory has been caused by a change in demand, unsuitable parameters, supply conditions, or poor allocation between locations;
• what specific action is needed in each case;
• how to prevent the same issue from recurring in the future.

Once StockM system has been implemented, initial parameters have been set, and the system has been allowed to operate for at least several replenishment cycles, a detailed view of inventory becomes available at SKU and location level. The analysis distinguishes critical products and their availability or stockout risk, fast-moving products, slow-moving products, and non-moving inventory positions.

This makes it possible to move away from one blanket solution for every item. Instead, the company can establish clear procedures for different situations so that employees know exactly which actions to take.

StockM helps not only identify these situations but also manage inventory levels systematically. For products facing a recurring risk of stockouts, the system can signal the need to increase the inventory buffer. For products whose inventory remains excessive for a long period, buffers can be reduced and replenishment can be stopped so that money is no longer invested in inventory with declining demand.

TOC methodology: where should inventory be held?

The fundamental question every company needs to answer is: where should it focus attention and invest in inventory to protect product flow, and where can that investment be safely reduced?

This is a more precise approach to working-capital management. In the Theory of Constraints (TOC) methodology, an inventory buffer is deliberately defined protection for a specific product at a specific location. Its purpose is to hold enough inventory to support sales or production while replenishment is taking place. The aim is not to hold the maximum possible quantity for every product.

This approach helps companies:

• retain inventory where it protects sales, customer service, or production continuity;
• review products that repeatedly face a stockout risk;
• identify products whose inventory remains high for a long period relative to real demand;
• reduce or stop replenishment when excess inventory becomes persistent;
• make clearance-sale, return, pricing, or assortment decisions for products that no longer have a clear role;
• work with suppliers on more appropriate order quantities, delivery frequency, and replenishment conditions.

TOC-based inventory management uses buffers to protect product flow against disruption and focus attention on conditions that may affect availability. The business value is not merely lower inventory. More importantly, it is better control over where and why the company’s working capital is being used.

Dynamic buffers: adapting to changing conditions

An inventory buffer can be understood as the planned level of investment for a specific SKU at a specific location. However, it should be a dynamic target that responds to what is happening in the market and in the supply chain.

As demand and supply conditions change, the appropriate level of inventory investment must change as well. A product whose consumption is steadily increasing, whose replenishment lead time has lengthened, or whose business importance has grown may require a larger buffer. A product with declining demand, increasingly reliable supply, or consistently excessive inventory may require a smaller buffer and a lower investment.

A 2021 simulation study, “Evaluation of dynamic buffer management for adjusting stock level: a simulation-based approach,” found that dynamic buffer management can reliably balance two inventory-management objectives: product availability and control of excess inventory. The study also emphasises that buffers should be adjusted in response to recurring changes, rather than a one-off fluctuation in demand.

In practice, this means that a company should not increase or reduce inventory merely because of one unusual order. It is important to determine whether the change is recurring and whether it reflects new customer demand, seasonality, a change in lead time, or another real operational factor.

Effective inventory management is a shared business objective

If inventory is viewed as a business investment, then involvement in inventory management should not be limited to the supply function. The best inventory-investment outcomes are achieved when finance, purchasing, sales, and supply teams assess it together.

Finance sees the money invested in inventory, cash flow, the risk of write-offs, and the cost of financing. Purchasing sees supplier terms, ordering constraints, lead times, and delivery reliability. Sales sees customer commitments, demand, promotions, and commercial opportunities. The supply team sees production needs, warehouse capacity, and order-fulfilment performance.

A useful cross-functional review does not need to cover every SKU. It should focus on inventory positions and recurring patterns that require a specific decision.

Example

Imagine a distributor with EUR 3 million invested in inventory. Management wants to improve cash flow and proposes reducing inventory by 10%.

An equal reduction across all categories would theoretically release EUR 300,000. However, it could also reduce the availability of the most important and highest-revenue products.

A detailed assessment at SKU and location level may reveal a different picture:

• several fast-selling A-category products are repeatedly out of stock;
• slow-moving products have remained in the warehouse for many months;
• some products are overstocked in one warehouse while unavailable in another;
• some inventory was purchased in large quantities to obtain supplier discounts or meet minimum order quantities;
• some products remained after a promotion or season had ended.

Such a solution shall involve retaining and possibly improving the availability of A category goods, limiting restocking of persistent surplus inventory, centralizing supplies as much as possible, negotiating better delivery conditions with suppliers, and conducting clearance sales or assortment adjustments for non-moving and declining goods.

The objective here is not EUR 300,000 of reduced inventory but better cash utilization: less money invested in non-profitable inventory positions and more resources freed for maintaining availability, settling accounts with suppliers, financing further growth or other goals of the company.

Inventory is an integral element of the business and should be managed as such

Inventory is an integral element of operations in numerous trading and manufacturing enterprises. It guarantees availability, protects customer service, assists in manufacturing, and helps react to demand.

But inventory is also an investment, which means that inventory management must be based on business logic. Each position of the inventory should serve some particular purpose: to meet expected demand, safeguard the fulfillment of a critical customer commitment, assure a continuous production process, cover actual replenishment lead time, or prepare for a future event. In case something is changing, the corresponding inventory position should be reconsidered too.

This is the practical link between inventory management and working capital management. It seeks to channelize funds to those inventories which help in profitable turnover and free up funds from those inventories which don’t do so.

By applying the TOC methodology and using a system such as StockM, this becomes a structured, continuous management process: maintaining the necessary inventory where it matters most, identifying excess inventory early, and adjusting investment levels as real demand and supply conditions change.

FAQ: is inventory an investment?