Thursday, June 28, 2018

Inventory Turnover Ratios

          Inventory Turnover = Cost of Goods Sold

Inventory turnover represents the average number of times per year that inventory "turns over" or that all goods are sold from inventory.  A higher, more rapid turnover is generally favorable, with goods being sold more quickly.  Rapid turnover may result from good inventory management, but it can be a symptom of an inventory shortage as well.

A lower, less rapid turnover may indicate overstocking or the presence of obsolescent goods.  Slow inventory turnover often coincides with liquidity problems, since working capital is tied up in inventory.  Slow inventory turnover may also result from planned seasonal build-ups or from making a large, bulk purchase to obtain a good price.

As with other turnover ratios, this one compares inventory at a single point in time to an entire period’s cost of sales.  To correct for seasonality or other anomaly, consider using average inventory in the denominator instead of the ending balance.

          Days Inventory Outstanding =                365                 
                                                          Inventory Turnover Ratio

This ratio expresses turnover as the average length of time in days between the purchase and the sale of inventory items.  A lower value (more rapid turnover) is generally more favorable, and interpretation and problems are similar to those of the Inventory Turnover Ratio.

The measures of liquidity for Smith Heating and Cooling, Inc. seemed to indicate that the company would be dependent upon inventory turnover to service short-term obligations.  Because of this, their inventory turnover ratios are crucial.

The company’s inventory turnover is only 2.11 times per year, so inventory is outstanding for an average of 173 days.  This is likely to be very problematic.  An analyst would want to explore how these rates compare to those of the company’s recent past as well as to those of other companies in the industry.  It would also be important to know if seasonal fluctuations are affecting the inventory balance and whether the goods are becoming obsolete as they sit.

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