Financial ratios define the relationships between the various components of the financial statements of a business that indicate its performance, and financial strengths and weaknesses. Financial ratios can be broadly classified into the following categories: Liquidity ratios, Financial leverage ratios, Asset Turnover ratios (inventory turnover), Profitability ratios, Market value ratios.
Asset turnover ratios, also called asset utilization ratios, point to how efficiently a business manages the conversion of its assets into sales. The commonly used asset turn over ratios are the receivables turnover ratio and the inventory turnover ratio. The inventory turnover ratio indicates how many times the inventory has been sold or turned over during a financial year. It can be calculated as: Inventory turnover ratio = COGS / Avg. Inventory.
The higher the inventory turnover ratio, the more efficient will be the inventory management. However, care should be taken to ensure against loss of opportunities due to non-availability of adequate stocks. Businesses often express inventory turnover in terms of inventory period or days’ sales in inventory which is calculated as: Inventory period (days) = 365 / Inventory turnover. A lesser inventory period indicates a better inventory management, as the conversion of inventory into sales is faster.
The inventory turnover varies from industry to industry. Therefore, in order to understand where a business stands in terms of its inventory turnover, it has to be benchmarked against the industry standards. Let us look at how the average inventory can be calculated. It can be done in the following three ways:
- By calculating the average of the daily inventory values for a year
- By averaging the month-end inventory values for 12 months
- By taking the year-end value of inventory
The first method is considered the best as it gives a more realistic picture of the inventory on hand. However, the second method is commonly followed by businesses across the world, as it takes into account the highs and lows to a great extent and hence is considered more acceptable. The third method is not considered acceptable as the physical inventory holding on any given day is hardly indicative of the seasonality, if any, in inventory holding. Another factor which affects the inventory turnover ratio is the inventory cost-flow assumption. Even if two companies have the same cost of goods sold value, their inventory turnover would differ depending on whether they follow the FIFO, LIFO or weighted average method for valuing inventory.
Let us now look at why inventory turnover is a valid predictor of performance and profitability of a business. Inventory is an asset of a business. A business holds assets with the intention of converting these into cash at a profit. However, if an asset is not turned over, the working capital of the company would get locked up in it and the business would face challenges of low profitability and cash crunch. If a business uses borrowed capital for purchasing inventory, idle inventory would result in increased finance costs. In addition, inventory not turned over would also contribute to increase in carrying costs such as storage costs and insurance costs.
Finally, a higher level of inventory may portray a rosy liquidity picture in terms of the current ratio (the ratio of current assets to current liabilities). However, reading the current ratio of a business in conjunction with the inventory turnover ratio would provide a realistic picture about its profitability. Therefore, improving the inventory turnover ratio would help a business to increase its competitive advantage in terms of higher profitability.