Reporting and Analyzing Inventories

Read this section, which focuses on reporting inventories and inventory turnover ratio.

Inventory Turnover Ratio

Inventory turnover is the measure of the number of times inventory is sold or used in a time period such as a year.


LEARNING OBJECTIVES

Explain how a company would calculate their inventory turnover ratio


KEY TAKEAWAYS

Key Points
  • The equation for inventory turnover is the cost of goods sold (COGS) divided by the average inventory.
  • 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.
Key Terms
  • turnover: The number of times a stock is replaced after being used or sold, a worker is replaced after leaving, or a property changes hands
  • COGS: COGS (cost of goods sold) is the inventory costs of those goods a business has sold during a particular period.
  • liquidity: An asset's property of being able to be sold without affecting its value; the degree to which it can be easily converted into cash.


Inventory Turnover Defined

In accounting, the inventory turnover is a measure of the number of times inventory is sold or used in a time period such as a year. This ratio tests whether a company is generating a sufficient volume of business based on its inventory. The equation forinventory turnover is the cost of goods sold (COGS) divided by the average inventory. Inventory turnover is also known as inventory turns, stockturn, stock turns, turns, and stock turnover.

 

Businesses need to manage their inventories.: Here a woman is checking stock of certain items to maintain an accurate record for dollars of inventory in stock.


Significance Of Turnover Rates

The turnover rate has several significant implications:

  • Inventory turnover measures the efficiency of the firm in managing and selling inventory: thus, it gauges the liquidity of the firm's inventory.
  • A low turnover rate may point to overstocking, obsolescence, or deficiencies in the product line or marketing effort. However, in some instances a low rate may be appropriate, such as where higher inventory levels occur in anticipation of rapidly rising prices or expected market shortages.
  • A high turnover rate may conversely indicate inadequate inventory levels, which may lead to a loss in business as the inventory is too low. This often can result in stock shortages.

In assessing inventory turnover, analysts also consider the type of industry. When making comparisons among firms, they check the cost-flow assumption used to value inventory and the cost of products sold.


Differences In Calculations

Some compilers of industry data (e.g., Dun & Bradstreet) use sales as the numerator instead of the cost of sales. The cost of sales yields a more realistic turnover ratio, but it is often necessary to use sales for purposes of comparative analysis. The cost of sales is considered to be more realistic because of the difference in which sales and the cost of sales are recorded.

Sales are generally recorded at market value, which is the value at which the marketplace paid for the good or service provided by the firm. In the event that the firm had an exceptional year and the market paid a premium for the firm's goods and services, the numerator may be an inaccurate measure. However, the cost of sales is recorded by the firm at what the firm actually paid for the materials available for sale. Additionally, firms may reduce prices to generate sales in an effort to cycle inventory. In this article, the terms "cost of sales" and "cost of goods sold" are synonymous.


Example Of Calculating Inventory Turnover

Abercrombie & Fitch reported the following financial data for 2000 (in thousands):

  • Cost of goods sold: $728,229
  • Beginning inventory: $75,262
  • Ending inventory: $120,997

Their inventory turnover is:

\dfrac{\$ 728,229}{\left(\dfrac{\$ 75,262+\$ 120,997}{2}\right)}=7.4 \text { times }