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A company is said to be more efficient when it keeps the least inventory on hand to make the sales it does. The systems of the company must be so efficient that goods are available for sale as and when required and spend the least amount of time waiting in a warehouse. This is because inventory has many costs associated with it. Until earlier it was known as the necessary evil. Not only is capital locked in inventory creating an opportunity cost, there are other costs involved like warehousing, security, insurance, pilferage and so on.
The idea that inventory should be minimized if not eliminated caught the fancy of management gurus from 1980’s onwards. Japanese companies showed how they could produce efficiently at lower costs by implementing Just in Time inventory systems. Many years later, Michael Dell revolutionized the computer industry with his made-to-order business model that enabled him to function with zero inventories and earning almost double the profits that entrenched competitors with deep pockets could manage.
Since inventory is such a make or break item in the financials of a company, there is obviously an interest amongst analysts and investors who want to have a close watch on its performance. Hence, the inventory turnover ratio is amongst their favorites. This article explains the inventory turnover ratio in detail.
Inventory Turnover Ratio = Cost Of Goods Sold / Average Inventory*
Like all ratios, inventory turnover ratio also needs the same context for the numbers to become meaningful. It needs to be compared with the performance of others. Usually the comparison is done between:
Caution must be exercised by the analysts in drawing conclusions based on the inventory turnover ratio. Sometimes companies buy large amounts of inventories to beat the forthcoming price hikes. This may show up as an increasing inventory turnover ratio but may not be a bad signal in reality.
Also analysts must be wary of change in inventory policies before calculating and interpreting this ratio.
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