Question

The following is a portion of the condensed income statement for Rowan, Inc., a manufacturer of plastic containers:

Required:
1. Determine Rowan's inventory turnover.
2. What information does this ratioprovide?

 

Answer 1

Requirement 1

Inventory turnover ratio  =   Cost of goods sold                                                       Average inventory                              =          $1,840,000                                                        [$690,000 + 630,000] ÷ 2                              =   2.79 times

Requirement 2

By itself, this one ratio provides very little information. In general, the higher the inventory turnover, the lower the investment must be for a given level of sales. It indicates how well inventory levels are managed and the quality of inventory, including the existence of obsolete or overpriced inventory. 

 

However, to evaluate the adequacy of this ratio it should be compared with some norm such as the industry average. That indicates whether inventory management practices are in line with the competition.

 

It's just one piece in the puzzle, though. Other points of reference should be considered. For instance, a high turnover can be achieved by maintaining too low inventory levels and restocking only when absolutely necessary. This can be costly in terms of stock out costs. 

 

The ratio also can be useful when assessing the current ratio. The more liquid inventory is, the lower the norm should be against which the current ratio should be compared.

The ratio also can be useful when assessing the current ratio. The more liquid inventory is, the lower the norm should be against which the current ratio should be compared.