To understand how important a company’s inventory is, many investors will look at the company’s inventory turnover ratio. It is an important factor for every business that deals with inventory. It gives an idea of how well the business can sell its inventory in a given time frame. A high turnover ratio shows that the company can quickly turn around its investments into cash, which is good for most businesses.
In this article, we will look at what the inventory turnover ratio is, how it works, and how to calculate it. So let’s get started!
What is the Turnover Ratio?
The inventory turnover ratio is a measure of how quickly a company sells its products and replaces them with new ones. It is calculated by dividing the cost of goods by average inventory for the same period. A higher ratio indicates strong sales, while a lower one may suggest weak sales. Conversely, too much or too little inventory can skew the ratio.
In simple words, a turnover ratio is a number that calculates how much inventory has been sold in a year. The higher the turnover ratio, the more efficient the company is at selling its products.
Importance of Turnover Ratio
An inventory turnover ratio is an important number for a company since it reflects how much control a firm has over its inventory. It also shows the relationship between a company’s sales and expenses.
A high turnover rate often indicates that a business’s investments in inventory are quickly being converted into cash, which helps supplement the earnings of the business. The items that are included in the calculation of inventory turnover include raw materials, work-in-progress and finished goods.
How to Calculate Inventory Turnover Ratio?
The inventory turnover ratio formula uses two different terms
# Average Inventory = (beginning inventory + ending inventory) / 2
Average inventory is the average amount of inventory that a company had at all points in time. It can be calculated by adding up all of the beginning inventories for the year and then dividing that number by two.
And finally
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
The cost of goods sold is all of the costs associated with turning inventory into revenue, like production costs. The average inventory is simply the total amount in stock at any given moment divided by two.
Example
ABC Clothing manufactures women’s clothing. The beginning inventory was 10,000 units at an average cost of $2 per unit, the ending inventory was 15,000 units at an average cost of $3 per unit, and the total amount of units sold in a given year was 130,000 units. To calculate ABC Clothing’s Inventory Turnover Ratio
First, we have to calculate the Average Inventory
Average Inventory = (beginning inventory + ending inventory) / 2
Average inventory = (10,000 + 15,000) / 2
Average inventory = 25,000 / 2
Average Inventory = 12,500 units
Now let’s find out the Inventory Turnover Ratio
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
Inventory Turnover Ratio = 130,000 units sold / 12,500 average inventory
Inventory Turnover Ratio = 10.4
So the results show that the stock velocity is 10.4 times i.e. 10.4 times the stock of finished goods is converted into sales.
Conclusion
So in this article, we showed how to calculate the inventory turnover ratio. We also talked about its importance and how it can be used by businesses to understand their inventory control strategies. The higher the turnover rate, the more efficient a company is at converting its investments into revenue.
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