A:

The inventory turnover ratio is an important efficiency metric, especially for those in retail. This ratio compares the amount of product a company has on hand, called inventory, to the amount it actually sells. This comparison informs a business about how efficiently it is selling its product. Among other things, companies use the inventory turnover ratio to help inform decisions about production, sales tactics and advertising.

The most accurate method of calculating inventory turnover is:

Inventory Turnover = Cost of Goods Sold / ((Beginning Inventory + Ending Inventory) / 2)

The calculation of inventory turnover can vary slightly from business to business. Some calculate this ratio by dividing total sales by inventory. However, because sales are typically recorded at market value and inventory recorded at cost, this comparison can produce falsely inflated results. For a more accurate ratio, most businesses use the cost of goods sold (COGs) as the numerator. Because it reflects the total cost of producing goods for sale and excludes retail mark-up, COGS is a more appropriate figure for this comparison.

In addition, most businesses experience fluctuating sales throughout the year, so the use of current inventory in this calculation can produce skewed results. To account for variations in selling rates, the average inventory is generally used as the denominator. The average inventory is calculated by adding the inventory at the beginning of the period to the inventory at the end of the period and dividing by two. This adjustment is especially important for businesses whose sales are seasonal.

All the information necessary to calculate a business's inventory turnover is available on its financial statements. COGS can be found on the income statement, and both beginning and ending inventory can be found on the balance sheet.

Assume a company has COGS totaling $150,000, beginning inventory of $75,000 and ending inventory of $12,000, reflecting the effect of seasonal sales. The inventory turnover rate for this period is $150,000 / (($75,000 + $12,000) / 2), or 3.45. This indicates that the company has sold its entire average inventory more than three times during the given period.

The optimal inventory turnover ratio depends on the business and the industry in question, so a business's current inventory ratio should always be compared to its past performance, as well as to the performance of other businesses in its sector. A low ratio is an indication either of poor sales or of overstocked inventory. Poor sales can be the result of ineffective advertising, poor quality, inflated price or product obsolescence. Excess inventory can be equally dangerous to a business because the typical return on unsold inventory is zero. Inventory sitting in a warehouse costs the business money to produce but generates no revenue.

While a high inventory turnover ratio is preferable to a low ratio, it is not always an indication of an efficient business model. A high ratio can reflect a highly efficient selling model. However, it can also be obtained by maintaining low inventory levels, which can lead to difficulty servicing customers in a timely manner. A high ratio due to anemic inventory may easily lead to a low ratio the following year due to a decline in the customer base.

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