Inventory turnover measures how many times a company sells its inventory, with high turnover indicating high demand. Accountants can use two formulas to calculate turnover and track it over time to evaluate efficiency and compare to industry standards. High inventory levels can increase costs, so companies aim to improve turnover to increase sales and reduce costs.
Inventory turnover represents how many times a company sells through its inventory. Retail stores often use this metric to determine the efficiency of their operations. High inventory turnover usually means that there is high consumer demand for the company’s products. Accounting ratios provide information on how to calculate turnover and assess a company’s efficient use of assets. Information from a company’s income statement and balance sheet is needed to calculate this value and evaluate operations.
A company has two options for calculating inventory turnover. First, the formula can break down sales by inventory; second, accountants can divide cost of goods sold by average inventory. Either formula will provide the information needed to review stock turnover and determine how well the company sells through its stock. Accountants can calculate the ratios at any time during the year. Monthly and annual calculations are generally the most common use of this accounting ratio.
An example is a company that has $125,000 in sales and $85,000 in inventory. The stock turnover for this company is 1.47, which means that the company sells through its full stock almost one and a half times each period. Assuming these formulas last a single month, the company needs to order at least half of its current inventory to meet sales. The index itself cannot really determine the efficient use of assets. Other steps are needed to prove efficiency or evaluate operations.
Accounting ratios are common benchmark tools for evaluating a company’s operations. Accountants can track inventory movements for several months at a time. The benchmarking process compares the current inventory turnover rate with prior periods in an attempt to discover whether the company’s inventory turnover is better or worse. Companies can also use the ratio to compare their operations to an industry standard. This helps the company discover whether it is operating better or worse under the same economic conditions as other companies.
High inventory levels are often a major disadvantage in retail businesses. Businesses typically experience increases in operating costs, which include transportation, processing, accounting and management activities and expenses. Companies use inventory turnover rates and review processes to determine whether they can improve inventory turnover in order to increase sales and reduce costs. For example, if a company’s inventory turnover is lower than the industry average, there is potential for increased turnover. Inventory turnover higher than the industry average, however, can indicate that a company is operating as efficiently as possible and cannot improve turnover.
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