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Financial Analysis | I

Inventory Turnover

An activity ratio (turnover ratio) that analyzes how effectively a company uses its inventory. It measures the number of times inventory is replaced during a specific period of time (usually a financial year). Using units, inventory turnover is given by the following formula:

Inventory Turnover Units

If a company keeps an inventory of only 5 units and sells 100 units during the year, inventory must completely turn over and be replenished 20 times. If, instead, inventory is 100 units, and 100 units are sold, inventory must turn over and be replenished only one time. In the first scenario, inventory activity is high or speedy, whilst in the other it is very low or slow. Each activity level has its own advantages and disadvantages. The high-level activity will reduce storage costs but at expense of giving customers a reasonable selection. The low-level activity will offer a wide selection, but will cause the firm to incur higher storage cots and will make it run the risk of obsolesce (items may not be sold in the future due to new offerings with better making, ingredients, technology, etc).

Inventory turnover can also be calculated in dollars as follows:

Inventory Turnover

For example, if the cost of goods sold is at the end of financial year $5 million and the average inventory is calculated as $10 million, the inventory turnover will be: $5 million/$10 million, or 0.5 times. This implies that the firm has managed to sell and replace 50% of its inventory over a given financial year.

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