Overview Of Inventory Turnover Ratio
All product companies produce things that are then distributed to the customer. The process requires, in most cases, a particular level of inventory to be maintained. Inventory holding comes at a cost, and as a result, it becomes important to manage the inventory levels. Inventory turnover is an important indicator of not just inventory but also the business health of an organization. An inventory turnover ratio measure the speed at which a company is selling is inventory.
A Low inventory turnover indicates weak sales, therefore, surplus inventory and a high inventory turnover indicates strong sales. It must be noted that one must compare inventory turnover ratio within an industry. For example: FMCG industry will usually have a high turnover ratio owing to the fast moving nature of the products. On the other hand, a high-end jewelry store will mostly have a low inventory turnover ratio. This is because it largely depends on the nature of the product being sold.
The ratio also has implications on return on assets (ROA). One can calculate the return on asset of a company using the inventory turnover ratio and the profitability. ROS is the speed at which a company sells inventory at a profit. It is only in combination with the profitability that a high or a low inventory turnover ratio makes any practically useful sense.
Another metric is Days Sales of Inventory which measures how long it takes a company to convert its inventory to sales. It is nothing but the reciprocal of inventory turnover ratio multiplied by 365, which is the no. of days in a year.
Inventory turnover is calculated as total sales divided by the average inventory. Average inventory can be calculated as:
(Initial/beginning inventory + ending inventory)/2
The reason for using average inventory is to avoid the impact of irregular inventory levels, which may arise out of seasonality or events like festivals or other unforeseen events on the inventory turnover ratio.
There is another approach for calculating inventory turnover ratio. In this approach, we consider Cost of Goods Sold (COGS) to calculate the inventory turnover ratio. This is understood to be a more accurate measure because the sales include markup as well and therefore can create error while comparing the ratios. Moreover, using sales instead of COGS tends to inflate the inventory turnover ratio.
Approach 1: Using Sales
Assume a company, ABC, achieved $5 million in sales while the COGS are only $2,375,000. The beginning inventory is $43,000 and the ending inventory is $47,000. This gives an average inventory of (23000 + 27000)/2 = $35,000.
If we consider the sales, the inventory turnover ratio will be $5,000,000 divided by 25000, which is equal to111. The Days Sales of Inventory is (1/111) * 365 = 3.28
Approach 2: Using COGS
For the same company mention above, if we use the second approach, we get a remarkably different number. The COGS is 2,375,000 and the average inventory is 45000. This gives us an inventory turnover ratio of 52, which is almost half of what we get from approach one. The Days Sales of Inventory is (1/52) * 365 = 7.01
Difficulties Encountered In Inventory Turnover Ratio
Many students, owing to a lack of understanding of the concept, commit the mistake of comparing Inventory Turnover ratio of organizations in different industries without considering the nature of product, the industry averages for profitability. Thus, the might come to wrong conclusions and declare a company with a healthy inventory turnover ratio as problematic and vice versa.
Moreover, many students tend to compare ratios that were calculated using different approaches. For example, as illustrated in the example earlier, if we compare an inventory turnover ratio calculated using total sales with inventory turnover ratio calculated using COGS we will get significantly erroneous results.
Another problem that student face is that they either use the initial inventory or the ending inventory while calculating the inventory value to use in formula. The error is further augmented if we have to calculate inventory value from a set of items given. Students tend to take the average of these inventory levels instead of weighted average, which will give drastically erroneous result.
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