The inventory turnover ratio is one of the most important financial ratios. Of all the asset management ratios, it gives the business owner some of the most important financial information.
The inventory turnover ratio measures the efficiency of the business in managing and selling its inventory. This ratio gauges the liquidity of the firm's inventory. It also helps the business owner determine how they can increase their sales through inventory control. Here is the calculation for the inventory turnover ratio:
Net Sales/Inventory = # Times
In order to calculate the ratio, you take net sales off the company's income statement and inventory off the balance sheet.
Interpretation: Generally, a high inventory ratio means that the company is efficiently managing and selling its inventory. The faster the inventory sells, the less funds the company has tied up. Companies have to be careful if they have a high inventory turnover as they are subject to stockouts.
If a company has a low inventory turnover ratio, then there is a risk they are holding obsolete inventory which is difficult to sell. This may eat in to a company's profit. However, the company may be holding a lot of inventory for legitimate reasons. They may be preparing for a holiday season in the case of the retail industry or preparing for a strike, among other reasons.
It is important for a business owner to understand why the inventory turnover ratio is high or low. In order to do that, the owner needs to look at the company's investment in inventory and determine what inventory is being most productive. It is also important to use comparative data such as time series (trend) or industry data with which to compare a company's inventory ratio in order to analyze whether it is too high or too low.