Inventory Turnover Ratio:
The Inventory Turnover Ratio is one of the Financial Ratios used to assess how often the inventories are replaced and sales performance over a specific period.
This ratio is normally used 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 advantages and disadvantages
- Low Inventory Turnover, including advantages and disadvantages
- 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 time, and we hope you will give us constructive feedback after you read this article.
Now, let’s 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:
This ratio uses the relationship between Average Inventories and Cost of Goods Sold or sometimes Net Sales to assess whether the entity has reasonable control in managing its inventories (Inbound), and Sales (Outbound).
This ratio link to the performance of the sale, warehouse, and purchasing departments. Don’t worry. You will understand this. The perfect ratio depends on the entity’s situation and experiences, nature, and environment.
No one can guarantee what the perfect inventory turnover ratio is. Let’s say the ratio is high. It might mean the entity has a sound 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 a 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 the inventory turnover ratio is high and the good and bad things about it.
High Inventory Turnover, including advantages and disadvantages:
Let’s 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 goes up, the ratio will be high and do so if the Average Inventories go down. The cost of Goods Sold going up might be because of increased sales during the period. And is also because of cost and the inventory valuation method.
For example, a periodic inventory system or perpetual inventory system. The value of average inventories is also an important factor that affects this ratio.
In conclusion, a high inventory turnover ratio is neither good nor bad. It depends on the real situation of the company.
Low Inventory Turnover, including advantages and disadvantages:
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 is a 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 to be 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’s 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 are very straightforward. You want to analyze or assess the total sales for the period. We should take both kinds of sales: credit and Cash sales, for the period for our calculation.
Whatever we select, it must be consistent. If the sales information is not available for your calculation, you could use the cost of goods sold in its state of it.
Here are the total inventories you want to analyze at the end of the period.
Let’s say, at the end of January 2016. All kind of inventories is included in the calculation. They are raw material, work in progress, and Finish goods.
Before analysis, we should ensure 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.
Now let’s move to the example and analysis to understand Inventories Turnover better. At the end of the example, we will analyze the result.
ABC is a company operating in the manufacturing industry with the following financial information. Sales for the period ended 1 January 2016 to 31 December 2016, USD 10,000,000. Inventories at the end of the period are USD 1,000,000.
What is the Inventory Turnover Ratio of ABC Company?
Well, now let’s 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, the Inventories Turnover of ABC is 10.
But what does it mean to us?
Analysis of Inventories Turnover Ratios
The ratio here is 10, meaning that sales are ten times higher than inventories. We cannot say whether this ratio is good or bad based on the calculation result.
We need the industry average and competitors’ figures to get a better analysis. Also, 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 lose clients or customers due to a lack of inventories.
Too low is also not good, which 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 finished 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.