Day 9 of Fundamental Investing
Continuing ahead with our Efficiency Ratio, the second one here is the Inventory Turnover Ratio.
What is it?
The inventory turnover ratio is an efficiency ratio that shows how effectively inventory is managed by comparing the cost of goods sold with average inventory for a period. This measures how many times average inventory is “turned” or sold during a period. In other words, it measures how many times a company sold its total average inventory dollar amount during the year. A company with $1,000 of average inventory and sales of $10,000 effectively sold its 10 times over.
This ratio is important because total turnover depends on two main components of performance. The first component is stock purchasing. If larger amounts of inventory are purchased during the year, the company will have to sell greater amounts of inventory to improve its turnover. If the company can’t sell these greater amounts of inventory, it will incur storage costs and other holding costs. The second component is sales. Sales have to match inventory purchases otherwise the inventory will not turn effectively.
How to calculate it?
Here's an image for the same:
What's its significance?
Inventory turnover is a measure of how efficiently a company can control its merchandise, so it is important to have a high turn. This shows the company does not overspend by buying too much inventory and wastes resources by storing non-salable inventory. It also shows that the company can effectively sell the inventory it buys.
This measurement also shows investors how liquid a company’s inventory is. Think about it.
Inventory is one of the biggest assets a retailer reports on its balance sheet. If this inventory can’t be sold, it is worthless to the company. This measurement shows how easily a company can turn its inventory into cash.
Creditors are particularly interested in this because inventory is often put up as collateral for loans. Banks want to know that this inventory will be easy to sell. Inventory turns vary with industry. For instance, the apparel industry will have higher turns than the exotic car industry.
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