Inventory Turnover Ratio:
Inventory Turnover Ratio is one of the Financial Ratios used to assess how often the inventories are replacing and sales performance over a specific period of time.
This ratio is normally used as a tool to assess how well the inbound and outbound system of inventories are, based on the strong relationship between the Cost of Goods Sold and Averages Inventories. What do we mean by this?
In this article, you will get the answer to this question and learn the important things related to inventory turnover. Those things include:
- The key concept of Inventory Turnover
- High Inventory Turnover including advantage and disadvantage
- Low Inventory Turnover including advantage and disadvantage
- Inventory Turnover Ratio Formula
- Example of Inventory Turnover Ratio with Calculation
- Interpret Inventory Turnover Ratio
You might jump to the specific areas you are looking for to save your time, and we hope you will give us constructive feedback after you read this article.
Now, let move to the key concept of inventory turnover and why it is related to the inbound and outbound system of inventories. This is the important key you need to know to interpret the ratio professionally.
Key Concept of Inventory Turnover Ratio:
Basically, this ratio uses the relationship between Average Inventories and Cost of Goods Sold or sometimes Net Sales to assess whether the entity has good control in managing its inventories (Inbound), and Sales (Outbound) or not.
This ratio link to the performance of the sale, warehouse, and purchasing department. Don’t worry. You will understand this. The perfect ratio depends on the situation and experiences, nature, and environment of the entity.
No one can guarantee what the perfect inventory turnover ratio is. Let say if the ratio is high. It might mean the entity has a good system to control the inventory system. But, it also means an entity does not have enough funds to buy in inventory for stock.
A low turnover ratio means the average inventories are high. That might mean an entity has enough funds to buy in inventories in a large amount to gain bark discount.
But, it also means the entity did not forecast its demand correctly, or sales performance is quite poor. That is why we said the inventory turnover ratio is linked to the entity’s inbound and outbound inventory system.
Okay, now we move to the deep explanation of why inventory turnover ratio is high and good things and bad things about it.
High Inventory Turnover including advantage and disadvantage:
Let break down the high inventory turnover ratio based on the formula and we got two important things here: Cost of Goods Sold and Averages Inventories.
If the Cost of Goods Sold going up, the ratio will be high and do so if the Average Inventories going down. Cost of Goods Sold going up might be because of an increase in sales during the period. And is also because of costing and the inventory valuation method.
For example, periodic inventory system or perpetual inventory system. The value of average inventories is also an important factor that affects this ratio.
Conclusion, a high inventory turnover ratio is neither good nor bad. It depends on the real situation of the company.
Low Inventory Turnover including advantage and disadvantage:
A low turnover ratio means a high value of inventories at the beginning and end of the period. It is straightforward. But, what causes a high amount of average inventories.
There are many reasons. For example, there large purchase of inventories at the beginning of the end. This causes a large number of inventories in the stock.
Poor demand forecasting also causes this ratio low due to over-purchasing. Poor sales performance leads to the low cost of goods sold due to sales revenue, and the cost of goods sold is linked very closely.
Now, let move to the formula.
Inventories Turnover Ratios Formula:
Inventory Turnover Ratio = Sales / Inventories
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory.
Sales or Net Sales here is very straightforward. It is the total sales for the period that you want to analyze or assess. We should take both kinds of sales: credit sales and Cash sales for the period for our calculation.
Whatever we selected, it must be consistent. If the sales information is not available for your calculation, you could use the cost of goods sold instate of it.
Inventories here is the total inventories at the end of the period that you want to analyses.
Let say, at the end of January 2016. All kind of the inventories is included for the calculation. They are raw material, work in progress, and Finish goods.
Before analysis, we should make sure that inventories are correctly calculated and measured. However, most books use Average Inventories to calculate this ratio when we use the Cost of Goods Sold for our calculation.
Now let’s move to the example and analysis to get a better understanding of Inventories Turnover. At the end of the example, we will analyze the result.
ABC is a company operating in the manufacturing industry, and it has the following financial information. Sales for the period ended 1 January 2016 to 31 December 2016, the amount USD 10,000,000. Inventories at the end of the period are USD 1,000,000.
What is Inventory Turnover Ratio of ABC Company?
Well, now let move to our calculation.
Here is the summary of ABC Financial Information for our calculation
- Sales = USD 10,000,000
- Ending inventories = USD 1,000,000
Based on the formula above, Inventories Turnover of ABC is 10 right. But what does it mean to us?
Analysis of Inventories Turnover Ratios
The ratio here is 10, and it means that sales are ten times higher than inventories. Based on the calculation result, we could not say whether this ratio is good or bad. To get a better analysis, we need the industry average as well as competitors’ figures. Also, the past data and experiences also very important to determine.
As we mentioned above, too high or too low Inventories Turnover Ratio is not good for the company. Too high means a risk for the company to lost clients or customers due to a lack of inventories.
Too low is also not good, and this could affect the operation, for example, out of stock. If we perform a financial analysis of the other company, a too low ratio indicates weak working capital. The company probably could not obtain or does not have enough funds to purchase raw materials for the product.
And probably, the company does not has enough funds to purchase finish goods. If that is the case, the company probably soon get the big trouble with the operation.
We hope this article helps you understand Inventories Turnover Ratio, and if you have any questions, please drop them here. We will try our best to help you.