Inventory Turnover = Cost of Goods
Sold
Inventory
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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