Question

The simple rule for inventory turnover is that a low ratio is preferable.

Answer 1

No, the above question statement is false and below is the explanation:

“The higher – the better”. A higher inventory turnover ratio (ITR) means that less inventory is required to support sales, therefore less warehouse space and capital are needed, which leads in turn to higher ROI and an increased bottom line.

In other words:

Inventory turnover ratio varies significantly among industries. A high ratio indicates fast moving inventories and a low ratio, on the other hand, indicates slow moving or obsolete inventories in stock. A low ratio may also be the result of maintaining excessive inventories needlessly. Maintaining excessive inventories unnecessarily indicates poor inventory management because it involves tiding up funds that could have been used in other business operations.

'Inventory Turnover'

Inventory turnover is a ratio showing how many times a company has sold and replaced inventory during a period. The company can then divide the days in the period by the inventory turnover formula to calculate the days it takes to sell the inventory on hand. It is calculated as sales divided by average inventory.

In other words:

Inventory turnover measures how fast a company sells inventory and analysts compare it to industry averages. Low turnover implies weak sales and, excess inventory. A high ratio implies either strong sales or large discounts.

Inventory turnover ratio (ITR) is an activity ratio and is a tool to evaluate the liquidity of company’s inventory. It measures how many times a company has sold and replaced its inventory during a certain period of time.

Formula:

Inventory turnover ratio is computed by dividing the cost of goods sold by average inventory at cost. The formula/equation is given below:

Inventory turnover ratio (ITR) = cost of goods sold / Average inventory at cost

Two components of the formula of inventory turnover ratio are cost of goods sold and average inventory at cost. Cost of goods sold is equal to cost of goods manufactured (purchases for trading company) plus opening inventory less closing inventory. Average inventory is equal to opening balance of inventory plus closing balance of inventory divided by two.

Note: If cost of goods sold is unknown, the net sales figure can be used as numerator and if the opening balance of inventory is unknown, closing balance can be used as denominator. For example if both cost of goods sold and opening inventory are not given in the problem, the formula would be written as follows:

Inventory turnover ratio (ITR) = Sales / Inventory