Inventory Turnover
The number of times the firm's inventory is sold or used over a specific period.
What Is Inventory Turnover?
Inventory turnover is the number of times the firm's inventory is sold or used over a specific period. This turnover can be calculated using the days of inventory formula, which calculates the days for which inventory is held in the company.
The formulas are as follows:
Inventory Turnover = Cost of goods sold / Average value of inventory
Where,
Cost of goods sold (COGS) = Beginning inventory + Purchases - Closing inventory
and
Average value of inventory = (Beginning inventory + closing inventory) / 2
A higher ratio concludes strong sales as it indicates that the company is selling the inventory quickly and not holding it for an extended period.
A lower ratio concludes weaker sales as it indicates that the company is holding onto too much inventory rather than selling it. So, a higher ratio is considered to be favorable.
We can also calculate the days which are utilized to sell the inventory by the following formula:
Average days to sell inventory = 365/ Days Inventory Turnover Ratio
This indicates the days the company holds the inventory until it sells it.
A lower number of days is considered favorable than a higher average day to sell the inventory. Lower input costs and higher sales contribute to an increase in the ratio.
Key Takeaways
- The inventory turnover ratio is measured as a financial tool that calculates how many times the business sells or uses its inventory in an accounting period.
- A higher ratio and fewer days to calculate the ratio is considered favorable.
- It helps evaluate the efficiency and contributes towards the firm's sales and profitability.
- It provides an estimate and does not guarantee accurate results, which may be manipulated.
- Strong sales and selling inventory faster would have less storage and holding costs.
understanding inventory turnover ratio
In other words, it is defined as how quickly the company sells or uses its inventory. In most industries, a ratio between 5 and 10 is a good balance between stock held and reordered.
Inventory must be analyzed to identify when goods should be ordered and in what quantity. This must be interpreted correctly as high turnover is good, but low turnover is challenging for the company.
Inventory affects the profits, tax liability, and value of assets of the company. So, the inventory should be managed with proper analysis and focus on balancing over-inventory and low-inventory to grab a higher turnover ratio.
A higher turnover ratio results from higher demand for the company's products in the market among consumers. It can be possible with effective advertising of the products or sales promotion in the market.
A few factors affecting inventory turnover are changing or improving technologies, changes in customer demands for the products, and management of the inventory in the company.
According to ACCA Global, the shorter the turnover period, the better for liquidity, as less cash is locked up in inventory.
Additionally, keeping inventory for a long time can cause it to become outdated. On the other hand, having insufficient stock might lead to production halts and unhappy clients.
This ratio can be improved by better anticipation of future needs, lower prices, more sales, better management of inventory, eliminating old stock, and reducing purchase quantity.
Advantages of inventory turnover ratio
The business seeks to increase the ratio because doing so will reduce storage and holding expenses and boost sales. A higher turnover rate specifies inadequate inventory levels, which may lead to a loss in business as the inventory is too low, resulting in stock shortages.
The following are some of the advantages of using the ratio:
1. Increased sales volume and profitability
This ratio helps to increase the volume of sales and hence increases the profitability of the company.
2. Evaluation of the efficiency of the company
This ratio evaluates the company's efficiency by analyzing its performance.
3. Inventory management
Inventory needs to be managed and must strike a balance that is neither storing too much inventory nor too little inventory.
The firm's working capital needs to be managed and ensure that the cash is not stuck, which can be used for generating revenue.
5. Reduction in obsolete stocks
This helps in reducing markdowns and obsolete stocks.
Disadvantages of inventory turnover ratio
Conversely, the following are some of the ratio’s disadvantages:
1. Estimate value
This ratio just gives an average number of times the inventory company sold its inventory and does not give an exact number.
2. Manipulation
Inventory can be manipulated easily and lead to significant issues while preparing the financial statements at the end of the accounting period.
3. Consequence
Higher expenses and loss of sales are the two consequences in the long run.
4. Lack of disclosure
Hiding some important details about the inventory of the company from the users of the financial information is against the full disclosure and materiality principle of accounting.
Examples of inventory turnover ratio
The following mark the examples and also its calculation.
A) Example 1
Calculate inventory turnover ratio and average days.
- Inventory at the beginning = $150,000
- Inventory at the end = $20,000
- Purchases = $80,000
Inventory Turnover = Cost of goods sold/ Average value of the inventory
= [150,000 + 80,000 - 20,000]/ (150,000 + 20,000)/ 2 = 210,000/ 85,000
= 2.47 times
Average days to sell inventory = 365 Days/ Inventory Turnover Ratio
= 365 days/ 2.47
=147.77 days (148 days approx.)
Therefore, this states that the company sells or utilizes its inventory 2.5 times over the specific period and takes 148 days to sell its stock on average.
B) Example 2
Compare the following two companies and calculate their inventory turnover and average days it takes to sell the inventory.
Black Sea Company:
- Opening inventory = $80,000
- Closing inventory = $20,000
- Purchases = $10,000
Open Sky Company:
- Opening inventory = $100,000
- Closing inventory = $40,000
- Purchases = $20,000
Black Sea Company
Inventory Turnover = Cost of goods sold/ Average value of the inventory
= 80,000 + 10,000 - 20,000/ 50,000
= 70,000/ 50,000
= 1.4 times
Average days to sell inventory = 365 Days/ Inventory Turnover Ratio
= 365 days/ 1.4
= 261 days
Open Sky Company
Inventory Turnover = Cost of goods sold/ Average value of the inventory
= [100,000 + 20,000 - 40,000]/ 140,000/ 2
= 80,000/ 70,000
= 1.14 times
Average days to sell inventory = 365 Days/ Inventory Turnover Ratio
= 365 days/ 1.14
= 320 days
On comparing both companies, it is assumed that Black Sea Company takes 261 days to sell its inventory which is less than Open Sky Company with 320 days over a specific period of time.
Therefore, the Black Sea Company with a higher ratio is considered better than the others as the higher percentage is considered favorable.
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