Evaluating Inventories The Inventory Turnover Ratio

The inventory turnover ratio is defined as sales divided by inventories:

Inventories

Industry average = 9.0 times.

As a rough approximation, each item of MicroDrive's inventory is sold out and restocked, or "turned over," 4.9 times per year. "Turnover" is a term that originated many years ago with the old Yankee peddler, who would load up his wagon with goods, then go off to peddle his wares. The merchandise was called "working capital" because it was what he actually sold, or "turned over," to produce his profits, whereas his "turnover" was the number of trips he took each year. Annual sales divided by inventory equaled turnover, or trips per year. If he made 10 trips per year, stocked 100 pans, and made a gross profit of $5 per pan, his annual gross profit would be (100)($5)(10) = $5,000. If he went faster and made 20 trips per year, his gross profit would double, other things held constant. So, his turnover directly affected his profits.

MicroDrive's turnover of 4.9 times is much lower than the industry average of 9 times. This suggests that MicroDrive is holding too much inventory. Excess inventory is, of course, unproductive, and it represents an investment with a low or zero rate of return. MicroDrive's low inventory turnover ratio also makes us question the current ratio. With such a low turnover, we must wonder whether the firm is actually holding obsolete goods not worth their stated value.2

Note that sales occur over the entire year, whereas the inventory figure is for one point in time. For this reason, it is better to use an average inventory measure.3 If the firm's business is highly seasonal, or if there has been a strong upward or downward sales trend during the year, it is especially useful to make some such adjustment. To maintain comparability with industry averages, however, we did not use the average inventory figure.

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