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What is an “inventory turnover ratio”? Why is it important?

This ratio measures the number of times a company’s inventory is turned over in a year. It may also be expressed as a number of days. A high turnover ratio is considered good. Also, from a working capital point of view, a company with a high turnover requires a smaller investment in inventory than one producing the same sales with a low turnover.

This ratio indicates management’s efficiency in turning over the company’s inventory, which can be compared with other companies in the same field. It also suggests how adequate a company’s inventory is for its business volume. There is no standard yardstick for this ratio since inventory turnover rates vary from industry to industry. Companies in the food industry, for example, will turn over their inventory faster than heavy manufacturing companies, where a longer period of time is required to process, manufacture and sell the finished product. It a company has an inventory turnover rate that’s above average for its industry, it will generally mean that a better balance is being maintained between inventory and sales volume. So there will be less risk of (1) being caught with a top-heavy inventory position in the event of a decline in the price of raw materials, or in the market demand for end products, and (2) wastage through materials and products standing unused for longer periods than anticipated with consequent possible deterioration in quality and/or marketability. On the other hand, if inventory turnover is too high compared to industry norms, problems could arise from shortages in inventory, resulting in lost sales. Since much of a company’s working capital is usually tied up in inventory, how the inventory position is managed has an important and direct effect on earnings. Examples of high turnover industries: baking, cosmetics, dairy products, food chains, meat packing, industries dealing in perishable goods, and quick consumption, low cost item industries. Examples of low turnover industries: aircraft manufacturers, distillers, fur goods, heavy machinery manufacturers, steel, and wineries. Formula Cost of goods sold/Inventory To calculate inventory turnover in days, divide 365 (days) by the inventory turnover ratio. To be most meaningful, the inventory turnover ratio should be calculated using cost of goods sold, as above. Since this information is not always shown separately, the net sales figure sometimes has to be used.

 

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