How to Calculate Inventory Turnover

For a company to assess their sales and purchases as regards inventories, they must know and understand the basic concept of an inventory turnover for this can greatly affect their assessments about their company as well as their mind-set on how to improve their system especially in the purchase and sales of inventory. An inventory turnover can greatly affect the company’s profitability in a certain way, which will be discussed later.

In order to know its impact on the company’s Statement of Comprehensive Income, let us first know the basics of an inventory turnover.

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What Is Inventory Turnover?

Inventory turnover, also known as inventory turns, merchandise turnover, stock turns, turns, or stock turnover, is the number of times a company sells and replaces its inventory of goods during a certain accounting period. An inventory turnover provides insight as to how the company manage its costs as well as the effectiveness of their sales efforts.You may also see store inventory.

To simplify, an inventory turnover is a measure of the number of times an inventory is sold or used in a time period such as a year.

How to Calculate Inventory Turnover

  1. Determine the cost of goods sold (COGS) from your annual income statement. COGS can also be computed as beginning inventory plus purchases less ending inventory.
  2. Add your beginning inventory to your ending inventory. Your beginning and ending inventories can be obtained from the balance sheet at the start and end of the time period, respectively.You may also see school inventory.
  3. Divide the sum of the beginning and ending inventories by two in order to calculate the average inventory.
  4. Calculate the inventory turnover by dividing the cost of goods sold by the average inventory.

Previously, the ending inventory was used instead of the average inventory. However, the standards were updated and average inventory was used instead as this is more reasonable since there might be companies with merchandise that fluctuates greatly throughout the year.You may also see application inventory.

How to Effectively Use the Inventory Turnover Ratio

Now that we already know how to compute the inventory turnover, it is proper that we would also know how to effectively use them in order to improve and enhance the operations in our company. Here are the things that you can do.You may also see system inventory.

1. Use inventory turnover ratio to calculate inventory turnover period

You can use the inventory turn rate to calculate the number of days it takes for a business to clear its inventory and this would only takes a few seconds. The number of days to clear your inventory is called the inventory turnover period. To compute for your inventory turnover period, you just have to divide 365 by the inventory turnover rate. The resulting number is the number of days it would take for a company to go through its inventory. Hence, if you have a turnover rate of 4, this would mean that you have 91 days or approximately three months of inventory on hand.You may also see asset inventory.

2. Benchmark your inventory turnover ratio against the industry

You might think of comparing your inventory turnover ratio with other industries to check whether you are profitable enough. In doing so, you must take note that different industries have different inventory turnover ratio, and comparison would be distorted if you would compare different industries. For example, never compare the inventory turnover of a supermarket and a car dealer for the supermarket sells perishable goods while the car dealer would naturally have a low turnover because of its product being a slow moving item.You may also see restaurant inventory

Furthermore, it is observed that low-margin industries tend to have higher inventory turnover ratios than high-margin industries because it must offset lower per-unit profits with higher unit sales volume. Hence, it is only fitting to compare only those companies within the same industry.You may also see simple inventory.

3. Measure the efficiency of your business

An inventory turnover can be used to measure the efficiency of the company in managing their inventory. Commonly, a higher value of inventory turnover indicates the company doing well and a lower value means the opposite and there may be difficulty in handling the inventory.You may also see blank inventory.

A higher turnover implies that the company is not buying too much inventory and wasting resources by storing non-salable inventory. It shows that the company can effectively sell the inventory it buys and sell them immediately.

On the other hand, an extremely low inventory turnover rate may be caused by overstocking or inefficiencies in the marketing effort and is not a good sign because products tend to deteriorate as they idly sit in the warehouse.You may also see moving inventory.

4. Reduce holding costs to increase profitability

Inventory turnover also indicates the briskness of the business. There would be higher holding cost for inventories that are sold only once a year than those that are sold many times in a year. The reasons for increasing inventory turnover and reduce inventory are as follows:

  • Increasing inventory turnover would reduce inventory holding cost or the amount you spent on rent, utilities, insurance, theft, and other costs to maintain the inventory.
  • With all other factors held constant, reducing holding cost would increase profitability since your holding cost would be lesser.You may also see data inventory.
  • Items that can quickly be sold would increase responsiveness to changes in customer demands while allowing the replacement for items that are obsolete.

5. Boost shareholder confidence

Lastly, the turnover ratio would show how liquid a company’s inventory is. Creditors, banks, shareholders, and other related parties would have the confidence in dealing with your company if you have a high inventory turnover for this would signify that you are effective in turning your inventories into cash.You may also see retail inventory.

Final Say

It is important that every company must know how to analyze their respective inventory turnover and take action on the results of the computation of the inventory turnover. The computations would mean nothing if this will not be used by the company in interpreting its previous as well as to plan and execute future actions with regard to the sale and purchase of their inventory.You may also see process inventory.

Now that you already know how to calculate the inventory turnover, you must work in analyzing it for it to be useful for the company.You may also see supply inventory.

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