Inventory turnover measures how many times inventory is sold and replaced in a given period. Low rates may indicate problems, while high rates suggest a healthy business. Two formulas can be used, but businesses must strike a balance in managing inventory and allocating funds. Turnover also reflects consumer interest.
Inventory turnover refers to the number of times inventory is sold and replaced within a given period, such as a year. Low turnover rates may suggest that stores are acquiring excess inventory, which may mean they are experiencing problems, while a high turnover rate indicates that a store is doing brisk business. Inventory turnover is one of many metrics used to gauge the financial health of businesses large and small, and business owners can periodically assess their inventory turnover to see how they’re doing.
Two different formulas can be used to arrive at inventory turnover numbers. In the first, people divide cost of goods sold by inventory. However, this method can be flawed because inventories are usually expressed in wholesale value, not retail value, which means that the result of this equation will be skewed. Instead, some people prefer to divide the cost of goods sold, reflecting the price paid by the company, by the average inventory. Using an average inventory avoids skewed results caused by seasonal changes, such as sweeping inventory differences that appear in November and December in many regions of the world.
Sometimes the rate is low because a business is stockpiling products in preparation for a big event, in which case the business may be perfectly healthy despite the fact that it has a low inventory turnover rate. Conversely, extremely high fees can serve as an alert that a store may not be keeping adequate supplies in stock, and consumers could become increasingly frustrated with a lack of choice caused by poor inventory management. Businesses must strike a balance when managing their inventory, using their funds wisely to generate the best returns.
The people who manage their inventories must also think about how they are going to allocate the funds. For example, a company might buy a very large lot of a particular item, tie up capital in inventory until it is sold, or it might buy a small lot, use the proceeds from that sale to buy another small lot, and so on. freeing up funds for other uses. Having too much expensive inventory on hand can be a bad idea for a business that needs financial flexibility, as it may be forced to sell inventory quickly to raise capital.
Inventory turnover also reflects consumer interest in the products a company sells. If a business experiences a high turnover rate that gradually slows to a low, it suggests that consumer interest may be waning and it’s time to make some inventory adjustments. Conversely, if a company’s turnover rate suddenly starts to skyrocket, it means there has been a surge in consumer interest that needs to be addressed.
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