IGCSE Rate of Inventory Turnover Analysis
In this lesson, we will learn how to calculate and interpret the rate of inventory turnover and compare inventory management performance across different years of the business, and with other businesses.
Related Lessons:
Purpose of Inventory Management
The rate of inventory turnover is one of the ratios used by businesses to measure its efficiency in managing inventory. Inventory management is important as inventory forms a large part of a trading business’ current asset. Since inventory can only be converted to cash after being sold, therefore, it is considered not liquid. As such, inventory holding directly affects a business’ liquidity.
Efficient inventory management means the business is able to:
- maintaining the right level of inventory on hand to meet customer demand
- avoid out-of-stock situations which results in loss of revenue
Calculation & Analysis
This ratio measures the rate at which a business sells and replenishes its inventory during the financial year.
To calculate, we take Cost of Sales divided by Average Inventory. This gives us the number of times inventory is replenished during the financial year.
Cost of sales / Average Inventory = x times
Average Inventory is calculated by taking Inventory at the beginning of the financial year plus Inventory at the end of the financial year, divided by 2.
(Opening Inventory + Closing Inventory) / 2
A high rate of inventory turnover means that the business is:
- Efficient in selling
- Selling the right product that consumer wants
Likewise, it may also signify a problem in managing its inventory. The business is buying insufficient stocks leading to frequent sell out. This results in lost sales and money since it is unable to meet customer demand.
Frequent replenishment can lead to high cost of purchase due to delivery cost and possible lost on trade discount. This causes profit to fall.
A low rate of inventory turnover indicates that the business is taking a longer time to sell its goods, so it needs to replenish inventory less frequently.
Possible causes include:
- Inefficiency in selling
- Holding low demand or obsolete products
This results in cash being tied up thereby causing liquid ratio to decline. Profit may also be reduced due to increase in storage and handling cost, obsolescence or theft.
To improve, the business may increase sales by:
- Reducing selling price
- Gives trade discounts or special promotions
- Advertise to raise brand awareness
The business may also reduce inventory on hand by having clearance sales for older stocks.
Of course, a low inventory turnover may not always point to an inventory management problem in the business. A low ratio could also be due to the business:
- Buying large amount of goods due to a major discount
- Stocking up for an upcoming event