Inventory turnover rate is a financial calculation that determines how many times a business replaces inventory to generate sales in a given period. It helps manage inventory levels and determine how much cash to tie up with inventory. Calculating the ratio helps understand how much inventory should be available on shelves at any given time. The best course of action is to determine the minimum amount of inventory the business needs to keep on hand and the number of times it should replenish its stock throughout the year to generate the same revenue as buying all of it.
An inventory turnover rate is a standard financial calculation that determines the number of times a business replaces inventory to generate the current level of sales in a given period of time, typically 12 months. The formal calculation is the cost of goods sold (COGS) during the year divided by the company’s average inventory investment. Average inventory is calculated by adding the company’s starting and ending inventory value for the year and dividing it by two. The inventory turnover ratio allows a business to properly manage its inventory levels and determine how much cash needs to be tied up with inventory at any one time.
Running a business involves a complex assessment of how best to use available resources to ensure stability and growth. One wrong decision can quickly lead to the demise of a company. Lack of liquidity means that the company cannot react to opportunities in the market or position itself to increase its market share and increase revenue.
One of the key elements of resource allocation is inventory management. Inventory tends to be a company’s single largest investment. Calculating a company’s inventory turnover ratio helps you understand how much inventory should be available on shelves at any given time of year. If the company buys all of its inventory needs early in the year and sells it slowly over the course of the year, its inventory turnover rate would be equal to one. While this seems like a productive way to manage inventory by paying for all needs early in the year, it actually hurts business by tying up cash in inventory that may not sell until the end of the year.
The best course of action is to determine the minimum amount of inventory the business needs to keep on hand and the number of times it should replenish its stock throughout the year to generate the same revenue as buying all of it. ‘inventory in the beginning. This is where the inventory turnover ratio comes into play. The report takes the COGS and divides it by the average inventory investment for the year. Therefore, the formula allows the business to determine the largest number of inventory turnovers it can handle during a year and still achieve the desired income level.
With the inventory turnover ratio, a business can determine that it can trade its stock four times a year and still achieve the same income levels as it would if it bought all of its stock up front, for example. Operationally, that means the company is expected to spend just a quarter of its inventory budget at the start of the year. This frees up working capital for the company to pursue other ventures instead of having cash on the warehouse shelves.
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