Inventory Turnover Ratio Analysis

Inventory Turnover Ratio Analysis

See Also:
Raise Inventory Turnover Ratio
Economic Order Quantity
LIFO vs FIFO
Financial Ratios
Days Inventory Outstanding

Inventory Turnover Ratio Analysis Definition

Inventory turnover ratio, defined as how many times the entire inventory of a company has been sold during an accounting period, is a major factor to success in any business that holds inventory. It shows how well a company manages its inventory levels and how frequently a company replenishes its inventory. In general, a higher inventory turnover is better because inventories are the least liquid form of asset. A Flash Report is a useful tool in measuring and managing inventory turns.

Inventory Turnover Ratio Analysis Explanation

Inventory turnover ratio explanations occur very simply through an illustration of high and low turnover ratios. Despite this, many businesses do not survive due to issues with inventory. A low inventory turnover ratio shows that a company may be overstocking or deficiencies in the product line or marketing effort. It is a sign of ineffective inventory management because inventory usually has a zero rate of return and high storage cost. Higher inventory turnover ratios are considered a positive indicator of effective inventory management. However, a higher inventory turnover ratio does not always mean better performance. It sometimes may indicate inadequate inventory level, which may result in decrease in sales.

Inventory Turnover Ratio Formula

The following inventory turnover ratio formulas are listed below:

Inventory turnover = Sales / Inventory Or Inventory Turnover = Cost of good sold / Average inventory


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Inventory Turnover Ratio Calculation

Inventory turnover ratio calculations may appear intimidating at first but are fairly easy once a person understands the key concepts of inventory turnover. For example, assume annual credit sales are $10,000, and inventory is $5,000. The inventory turnover is:

10,000 / 5,000 = 2 times

For example, assume cost of goods sold during the period is $10,000 and average inventory is $5,000.

Inventory turnover ratio: 10,000 / 5,000 = 2 times

This means that there would be 2 inventory turns per year. That is a company would take 6 months to sell and replace all inventories.

Inventory Turnover Ratio Analysis Example

For example, Derek owns a retail clothing store which sells the best designer attire.  Derek worked in the apparel industry for quite a while, thus is well suited for the operations of his company. Still, Derek has a little to learn about the business of retail clothing. He studied the subject with passion and wants to grow his business. From his study, he realized that inventory turnover is the key to his business. First, Derek talked to his accountant for inventory turnover ratio analysis. You need somewhat of an expert because the matter is more complicated than the abilities simple, web-based inventory turnover ratio calculator.
His accountant comes up with a figure which Derek would like to increase. Annual credit sales are $10,000 and inventory is $5,000. The inventory turnover is:

10,000 / 5,000 = 2 times

Derek decides, from this, that he needs to make some changes. So he aligns a few strategies to move his products. First, he considers marking-down styles from the previous season as each season approaches. Similarly, he considers product give-aways with minimum transaction amounts. Then Derek considers the option of spreading contests and deals on social networking websites. He then finishes his evaluation by finding ways to turn his extra inventory into a tax write-off. Derek applied his newly found skills and knowledge to better his business. As a result, Derek looks forward to the future.

Cash Tied Up In Inventory

When your cash is tied up in inventory, it is bad news for your company. Make it your goal to increase inventory turnover to free up cash. For more ways to improve your cash flow, download the free 25 Ways to Improve Cash Flow whitepaper.
 

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Resources

For statistical information about industry financial ratios, please go to the following websites: www.bizstats.com and www.valueline.com.

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