Assessing Inventory Management
Read this section, which focuses on efficiency metrics and the impact of inventory method on financial statement analysis.
Efficiency ratios for inventory measure how effectively a business uses its inventory resources.
Describe how a company uses efficiency metrics to monitor inventory
- An efficiency metric or ratio, sometimes referred to as an activity ratio, is a type of financial ratio. The inventory turnover rate is a type of efficiency metric.
- Financial ratios evaluate the overall financial condition of a corporation or other organization in comparison to its industry and competitors.
- A low inventory turnover rate may point to overstocking, obsolescence, or deficiencies in the product line or marketing effort.
- A high turnover rate may indicate inadequate inventory levels, which may lead to a loss in business as the inventory is too low.
- Cost of Goods Sold: refers to the inventory costs of the goods a business has sold during a particular period (sometimes abbreviated as COGS).
- obsolescence: The process of becoming obsolete, outmoded, or out of date.
Efficiency Metrics (Ratios)
An efficiency metric or ratio, sometimes referred to as an activity ratio, is a type of financial ratio. Management, financial analysts, and the investment community evaluate financial ratios when trying to evaluate the overall financial condition of a corporation or other organization. Ratios can be expressed as a decimal value, such as 0.10, or given as an equivalent percent value, such as 10%. Some ratios are usually quoted as percentages, especially ratios that are usually or always less than 1, while others are usually quoted as decimal numbers, especially ratios that are usually more than 1. Efficiency ratios for inventory are used to measure how effectively a business uses its inventory resources in comparison to its industry or competitors.
Efficient use of inventory is critical for businesses.: Picture of inventory at a business.
It's important for organizations to strike the right balance on their inventory levels. If inventory levels are too low, the company runs the risk of losing out on sales and not meeting customer demand. This can lead customers to give their business to the company's competitors. When there is excess inventory, a company can have higher operating costs due to greater inventory storage requirements, which will decrease profits. In addition, excess inventory increases the risk of losses due to price declines or inventory obsolescence.
Types of Efficiency Metrics (Ratios)
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory (to calculate average inventory, add the balances of beginning and ending inventory and divide by 2)
The inventory turnover ratio is a measure of the number of times inventory is sold or used in a time period, such as a year. A low turnover rate may point to overstocking, obsolescence, or deficiencies in the product line or marketing effort. A high turnover rate may indicate inadequate inventory levels, which may lead to a loss in business as the inventory is too low.
Inventory Conversion Ratio = 365 Days / Inventory Turnover Ratio
The inventory conversion ratio is a measure of the number of days in a year it takes to sell inventory or convert it into cash.
Source: Boundless, https://courses.lumenlearning.com/boundless-accounting/chapter/assessing-inventory-management/
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