Study: Compute and Understand the Inventory Turnover Ratio
|
1. Read the Inventory Turnover ratio
Links to an external site. definition. |
Alternative Topic Formats: |
Take the topic quiz, by clicking here or clicking the "Next" button at the bottom right of this page.
Score at least 4 out of 5 on the quiz before moving on. If you do not score at least 4 out of 5 on the quiz, restudy the material and try again.
I will keep your highest score.
The videos, images and transcripts below provide the same content as provided in Step #1 above. It has simply been broken down into smaller, bite-sized pieces for easier access and review.
Slides 1-4 (0m:49s)
Links to an external site.
Welcome to Introduction to Accounting Preparing for a User's Perspective
Compute and Understand the Inventory Turnover Ratio
What can the inventory turnover ratio tell you?
The inventory turnover ratio indicates how effective and efficient management is at purchasing inventory from suppliers and selling it to customers.
When management holds inventory too long bad things can happen to it. For example, milk can go bad, computing technology can become obsolete, fads can pass, and oversupply can result.
Some products, such as Christmas trees only have seasonal demand so it is essential that management know its product, its business, its industry and its sales cycle to ensure it doesn't wind up with too many Christmas trees the day after Christmas.
Slides 5-6 (1m:18s)
Links to an external site.The higher the inventory turnover ratio, the fewer days sales of inventory it has, and, in general the better it is for the company; however, because different industries tend to have different inventory turnover ratios, if you want to make a fair assessment of management you should compare a company's ratios to competing companies in the same industry. For example, it wouldn't make a lot of sense to compare the ratios of a grocery store with an inventory turnover ratio of 24, to the those of a high-end jewelry store with an inventory turnover ratio of only 4. Because the two industries are so different, a comparison of their inventory turnover ratios would probably not reveal very much about their management's effectiveness and efficiency because they operate under different circumstances. Grocery stores turn their inventory over more often, but tend to have lower gross margins. Jewelry stores turn their inventory over less often, but tend to have higher gross margins. Both companies; however, have the ability to be very profitable.
If a business were able to turn its inventory over every month (i.e. about every 30.42 days), it would have an inventory turnover ratio of 12 times per year, meaning it purchases and sells an amount equal to its average inventory balance (which includes raw materials, work-in-process, and finished goods inventories) 12 times per year.
Slides 7-8 (1m:53s)
Links to an external site. When a company has a high inventory turnover ratio it will have a low number of days sales sitting in inventory. If it has a low inventory turnover ratio, it will have a high number of days sales of inventory. The "days sales of inventory" ratio effectively says, "If we stop buying inventory today, how many days will it take us to sell off all of our remaining inventory?"
Let's assume that two banana retailers, Brown Banana Co. and Yellow Banana Co had inventory turnover ratios of 5 and 60, respectively. Assuming bananas ripen within one week of being picked, which company's management appears to be doing a horrible job at getting the bananas sold before they over-ripen and have to be thrown away? Which of the two companies is probably on the quickest path to failure because of its inability to efficiently and effectively manage its banana purchases and sales? As with the AR turnover ratio, a company's days sales of inventory is computed by dividing 365 by the number of times the company turns its inventory over each year:
- Brown Banana Co. has 73 days sales of inventory on hand (i.e. 365 days per year / 5 inventory turnover ratio);
- Yellow Banana Co. has 6.08 days sales of inventory on hand (i.e. 365 days per year / 60 inventory turnover ratio)
Per the computations above, Brown Banana Co. needs 73 days to sell its bananas whereas Yellow Banana Co. only needs 6 days to sell its bananas. Yellow's shorter days sales of inventory indicates that its management is able to more quickly get its bananas sold to customers. By selling its inventory more quickly, as compared to Brown, Yellow will probably be more able to:
- sell its bananas before they turn brown,
- sell its bananas at full price,
- lower its inventory carrying costs Links to an external site.,
- increase liquidity to pay off current liabilities when they come due.
Slides 9-10 (1m:11s)
Links to an external site.In general a low inventory turnover ratio and a high number of days sales of inventory can be a sign of ineffective and inefficient inventory and sales management. For example, management may be:
- purchasing and/or producing too much inventory based on incorrect estimates of customer demand, possibly resulting in inventory spoilage,
- holding inventory too long rather than discounting it to get it sold, possibly resulting in inventory obsolescence,
- using an ineffective sales and marketing strategy, possibly resulting in reduced sales,
- etc.
In general a high inventory turnover ratio and low days sales of inventory is a sign of effective and efficient inventory and sales management; but when a company's days sales of inventory becomes too short it can also create problems. For example, a company with only a few days sales in inventory may actually experience "stock-outs" resulting in customers purchasing the stocked-out item from the company's competitors. For example, when we have Hurricane warnings in Hawaii some grocery stores have "stock-outs" on various food items as people rush to get prepared for the oncoming storm.
Slides 11-12 (1m:07s)
Links to an external site.Many successful businesses purposely choose to hold more inventory than is immediately needed for one or more of the following reasons:
1) Cycle stock. Management repurchases additional inventory based on a given reorder point. For example, some companies simply draw a red line on the product's shelf and decide to reorder whenever their inventory drops below the red reorder-line. Others use sophisticated and automated just-in-time
Links to an external site. reordering systems.
2) Safety stock. Management purchases additional inventory during key selling seasons to handle seasonal demand such as for the Christmas shopping season.
3) Psychic stock. Management purchases additional inventory to ensure its store shelves are always totally full to give customers the feeling that the company has more than enough to meet their needs. Stores that look empty tend to drive customers away.
All three of these reasons for purchasing excess inventory will tend to reduce the number of times a company turns its inventory over and will increase its days sales of inventory resulting in increased inventory carrying costs Links to an external site. but such increased costs are often justified by being able to reduce stock-outs and increase customer satisfaction.
Slide 13 (0m:17s)
Links to an external site.Managing inventory on hand is a balancing act between having either too much or not enough inventory on hand. When company's don't have enough inventory, they can miss out on sales, if they have too much, they will incur higher inventory carrying costs
Links to an external site..
Slides 14-15 (1m:04s)
Links to an external site.How do you compute the inventory turnover ratio?
The inventory turnover ratio is computed as follows:
Example: Assume Company A incurred $1,000 of Cost of Goods Sold during the year, its beginning inventory was $170, its ending inventory was $230 totaling to $400, which is then divided by 2 for an average Inventory balance of $200. Its inventory turnover ratio would be 5 as follows:
This means that on average, Company A was able to purchase $200 worth of inventory and then sell it, then purchase another $200 worth of inventory and then sell it, etc. 5 times during the year. But what really does a "5" mean. Unless you compare it to the past, compare it to competitors or use it to compute the number days it takes the company to sell its inventory, the inventory turnover ratio is kind of a useless number.
Slide 16 (0m:28s)
Links to an external site.If we were to take 365 days and chop it up into 5 equal collection periods, we would realize that the company takes 73 days to sell its inventory computed as follows:
Now if the industry normally takes only 20 days to sell its inventory, it would seem that Company A's management is not very effective or efficient at getting its inventory sold.
Slide 17 (1m:04s)
Links to an external site.Let's now tie the inventory turnover ratio and the days sales of inventory together to show that if you already know 3 of the four variables, you can solve for the missing one.
Example: Let's assume that New Co. has 28 days sales of inventory and you know it has Cost of Goods Sold of $40 M, can you use your understanding of the inventory turnover ratio and the days sales of inventory to solve for New Co's Average Inventory balance? The answer is "Yes you can". Just review the math and related video discussion below:
Slide 18 (0m:51s)
Links to an external site.How do you use the inventory turnover ratio?
Once we know what a company's inventory turnover ratio is (i.e. 13.03) and how many days it takes to sell its inventory (i.e. within 28 days) we should take our analysis one step further and compare the company's ratios to its own ratios from prior years to determine whether its management is getting more or less effective and efficient at managing its inventory and sales.
Please review the inventory turnover ratios and the days sales of inventory periods for the years noted below to determine whether you think management has improved or gotten worse at managing its inventory and sales.
Due to the fact that the company's inventory turnover ratio is decreasing and its days sales of inventory is increasing, it would appear that management is holding its inventory for a longer period of time which could lead to spoilage, obsolescence and an overall increase in inventory carrying costs Links to an external site..
Slides 19-21 (0m:58s)
Links to an external site.In addition, as noted previously, wise users will also compare a company's inventory turnover ratio and days of inventory to the industry averages as a means of benchmarking its performance as indicated in the example below:
| Inventory Turnover Ratio | Days Sales of Inventory | |
| Company | 60.0 | 6.08 |
| Industry | 52.9 | 6.90 |
If Yellow Banana Company has an inventory turnover ratio of 60 and is therefore taking 6.008 days to sell its inventory but the industry has an average inventory turnover ratio of 84.89 thus taking only 4.3 days to sell, management might want to review its inventory and sales processes to ensure that it is being as effective and efficient as possible.
In summary, you should be able to:
- define and compute the inventory turnover and days sales of inventory ratios
- use these ratios to assess management's ability to properly manage its inventory as compared to its own past performance as well as to its industry.
Good luck on the quiz.