Inventory turnover is a widely used performance measure that reflects the liquidity of a firm’s inventory and the speed with which inventory is converted into sales.
This indicates the number of times the inventory is sold or turned over during a stated period.
Inventory turnover ratio = Cost of goods sold
Average inventory value
e.g, if the firm’s annual cost of goods sold = Rs.5,00,000 and its average inventory value = Rs.50,000, the inventory turns over 10 times. If the cost of goods sold rises to Rs.10, 00,000 and the value of the inventory remains as it is, the turnover ratio jumps to 20.
Inventory turnover is related to actual sales. Hence high inventory levels are not penalized if the sales are very high and low inventory levels are not rewarded, if the sales are low. If the inventory turnover is high, it means that the inventory is kept in stock for a less period of time and hence it is more liquid. The cash flow needed to finance the inventory also decreases as the number of inventory turnover increases. A high level of sluggish inventory amounts to unnecessary tie-up of funds, reduced profits and increased costs. If these inventories are written off, it will adversely affect the Working capital and liquidity position of the firm. However, if the inventory level is maintained at a very low level (inventory turnover high), then it may result into frequent stock outs, which means the firm replenishes its inventory in small lot sizes. This may be costly to the firm.
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