» Stock Investing Basics » Understanding Inventory Turnover Ratio

Inventory Turnover Ratio

Inventories represent stocks of ready made goods or raw materials that are needed to be kept in order to be able to meet the orders of clients. Their management represents a significant challenge to managers since keeping the right level of inventories is a key to an efficient management of resources. Thus, most manufacturers have to deal with warehouses in which to put their productions and materials.

As for retailers, they also have inventories in terms of ready made goods that have to be sold to clients. If inventories are piled up, money is needed to store them. Additionally, money is needed to purchase inventories in order to keep the needed level to meet the orders of clients. So, the main goal of management teams is to find the most efficient level of resources which will help them meet the orders of their clients.

Evaluating the Level of Inventory

The level of inventory that should be kept depends from one company to another. For instance manufacturers and retailers should have a higher level of inventory, whereas software makers or advertising companies require lower levels of inventories. When you evaluate the inventory levels of a company you should compare its inventories to that of its rivals. Try to make the comparison in terms of percentages. Another thing you should check is the increase in inventories. If it is rapid you should study the reasons for this.

You should study inventories in comparison with the company's sales. This should be done, because the inventory levels of a company may have increased just because it has more orders and sales to meet. However, you should be cautious if the company increases its inventory levels without the corresponding increase in sales and orders.

Inventory Turnover Ratio

The inventory-turnover ratio gives a general view on the inventories of a company. In order to calculate it you should divide the annual sales of the company by its inventory.

Inventory Turnover = Sales / Inventory

The result represents the turnover or inventory or how many times inventory was used and then again replaced. This number is representative for a one year time period. If the value of the inventory-turnover ratio is low, then it indicates that the management team doesn't do its job properly in managing inventories.

For example, company ABC has $10 million in sales for the previous year. Its inventory for the same year is $50 million. So, its inventory turnover ratio is 0.2, which is significantly low and means that the company will need five years to deplete the existing inventory.

You should compare the turnover ratios of companies in order to determine their efficiency of inventory management. Between companies with different inventory turnover ratios you should select the one with higher turnover, because it indicates higher inventory efficiency.

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