Describe the inventory turnover ratio

Inventory Turnover

The inventory turnover ratio indicates how fast firms sell their inventory items, measured in terms of the rate of movement of goods into and out of the firm. Inventory turnover equals cost of goods sold divided by the average inventory during the period.

Managing inventory turnover involves two opposing considerations. On the one hand, for a given amount of gross margin on the goods, firms prefer to sell as many goods as possible with a minimum of assets tied up in inventories. An increase in the rate of inventory turn-over between periods indicates reduced costs of financing the investment in inventory. On the other hand, management does not want to have so little inventory on hand that shortages result in lost sales. Increases in the rate of inventory turnover caused by inventory shortages could signal a loss of customers, thereby offsetting any advantage gained by decreased investment in inventory. Firms must balance these opposing considerations in setting the optimum level of inventory and, thus, the rate of inventory turnover.

Some analysts calculate the inventory turnover ratio by dividing sales, rather than cost of goods sold, by the average inventory. As long as the ratio of selling price to cost of goods sold remains relatively constant, either measure will identify changes in the trend of the inventory turnover ratio. Using sales in the numerator, however, will lead to incorrect measures of the inventory turnover ratio for calculating the average number of days that inventory is on hand until sale.