Evaluation of the inventory turnover ratio The following information was taken f

Question

Evaluation of the inventory turnover ratio

The following information was taken from the accounting records of three competitors for the 2016 fiscal year.

Problem:

a. Explain how to calculate inventory turnover and the number of days sales in inventory.

b. What do the two ratios tell us about inventory?

c. Compare the ratios for the three companies and comment on the results. What might contribute to the lower turnover and higher number of days sales in inventory at Company A?

Explanation / Answer

a. Inventory turnover is calculated using the formula : Cost of Goods sold/Average Inventory

The formula for Number of days sales in inventory is: Number of days in a year/Inventory Turnover ratio

b. Inventory turnover ratio tells us how effective the company has been in converting its inventory into sales. How many times the inventory has been sold is what the term "turnover" refers to here. In other words, this ratio shows us how liquid the company's inventory is.

Number of days sales in inventory shows us how many days the company's inventory is tied up before selling it. Generally a shorter number of days is preferred as it means that the inventory is not tied up for too long. In effect,if a company's inventory is tied up for too long, it means that the company's cash is tied up in inventory.

c. Inventory Turnover Ratio: Out of the 3, we can see that Company C has the maximum inventory turnover ratio. This shows that it is the most effective in turning its inventory into sales. Company B is also not far behind in this aspect. However, Company A has a fairly lower ratio, meaning that it is not able to convert its inventory as efficiently as the other two.

Number of Days sales in inventory: This is yet another measure of effectiveness in inventory management. This correlates with the inventory turnover ratio analysis as we can see that Company C has the lowest number of days sales in inventory. A good inventory turnover ratio also means that the inventory is not locked up for too long. And that is the reason that Company C has the lowest number of days sales in inventory. On the other hand, since the turnover is relatively lower for Company A, the number of days it is holding on to inventory is high.

Company C is the best in managing inventory with Company B not fair behind. Company A however, is not as effective in managing its inventory.

Company A ratio reason: One of the reasons for a lower turnover ratio and higher number of days sales in inventory could be large purchases in excess of that required by the sales department. This increases the holding period and reduces the turnover where the company cannot sell as much it purchased. There should therefore be proper communication between the purchase and the sales department.

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