What is  Inventory Turnover Ratio ?

Inventory is a component of current assets and it contributes towards sales in diverse ways. Availability of inventory assures the management that sales are guaranteed and hence no loss of market share to the competitors. Also, investment in inventory is a way of ensuring that net profit is not over exaggerated and on the same breath, sales is not over eroded especially when we want to determine gross profit at the end of the year. There are other many ways that inventory contribute to sales which culminates in to the efficiency level portrayed by the inventory turnover ratio as explained here below.

This quotient is a pointer of the efficiency with which investment in inventory portrays towards sales via Cost of Goods Sold (COS). It is demonstrated as follows;

inventory-turnover-ratio

Interpretation

Inventory turnover depicts the number of times an organization has sold and replaced inventory during a specific period. A organization can then divide the days in the period by the inventory turnover model to establish the number of days it takes to sell the inventory at hand.

NB: Average Inventory composes the sum of opening inventory plus closing inventory divided by two

Example

Ability co ltd provided you with the following trial balance for the period ended 30th/04/2017

Additional information

Closing inventory was valued at $250,500.

Required determine the inventory turnover ratio and interpret the results

Solution

This means available inventory is sold and more is bought and again sold nine (i.e 9.3) times within the given period, usually one year.

Further, assuming that a year has 365 days, then the time duration in days that it takes the business to sell the inventory it had purchased will be given by

Applicability of inventory Turnover Ratio in Decision Making by Management     

The formula of inventory turnover ratio is composed of

yet we are talking of its contribution to net sales. This is very much in order for the size of COS determines whether the gross profit will be beefed up or eroded down.

In this formula, the denominator factor is average inventory whereas the numerator is cost of goods sold (COS)

Denominator factor; guides the management to be selective when purchasing inventory by ensuring that the component is of high quality so as to be fast moving. As a result of being fast moving then the total number of times inventory will be bought and sold will be more. This helps in over performing.

On the other hand, if the goods selected are of slow moving, the inventory turnover ratio will be small, an indication of poor performance of the company and this may result to loss of market share to its competitors.  In a nutshell, a slow turnover implies weak sales and possibly excess inventory, while a faster ratio implies either strong sales or insufficient inventory.

Numerator factor; COS is already predetermined for cost of goods is already known for it has been paid for or incurred and the management can do very little to control this value. So the management need to focus more on the denominator factor than the cost of goods sold.