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Inventory Turnover Ratio

Inventory Turnover Ratio Assignment / Homework Help
The inventory turnover, or stock turnover, measures how fast the inventory is moving through the firm and generating sales. It establishes the relationship between the cost of goods sold during the period and average inventory held during the period. It is computed as:

Cost of Goods Sold
Average Inventory

Higher the ratio, greater is the efficiency of inventory management. The importance of inventory turnover can also be looked from different point of view i.e. it helps the analyst measure the adequacy of goods available to sell in comparison to the actual sales orders.

In this regard, the presence of inventory involves two risks:
  • Running out of stock due to low inventory (high turnover) which may indicate future shortages.
  • Excessive carrying charges because of high inventory (low turnover).

One has to manage carefully between running out of goods to sell and investing in excessive inventory otherwise it will result in either a higher or low ratio, which may be an indication of poor management. The analyst should keep in mind that high and low turnovers are relative in nature. The current turnover must be compared to previous period or to some industry norms before it is branded as high, low, or normal. The nature of business should also be considered in analyzing the appropriateness of the size and turnover of the inventory.

A meaningful conclusion about the inventory turnover can be arrived after studying its composition, its change over the years and comparing the turnover trends with the industry.

Example:

A company has the following turnover and asset numbers taken from its balance sheet.

 Year 2009   Year 2008 
Turnover $2,654,900 $2,086,450
Inventory $ 509,179 $ 453,332

Accounts receivable turnover ratio:

            $ 2,654,900            
($509,179 + $453,332) / 2

$ 2,654,900
  $ 481,255

5.52 times


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