Inventory Turns Calculation

Offers Clues To A Company’s Health

By: - Management - May 24, 2011
inventory turns calculation

Just about everyone, at one time or another, has heard a businessperson refer to “inventory.”

“I have to check my inventory to see if I have it.”

“We are closed the last day of this month for inventory.”

What are they really talking about?

Inventory, as defined by Webster’s is “an itemized list or catalog of goods and property.” It is also “a list of the stock of a business taken annually.”

Well, it is a lot more than those things when it comes to properly running a business. So much so that an important tool of management has become the “inventory turns calculation.”

“Inventory turns” is another way of saying turnover and the calculation will usually tell a lot about the fortunes of a business.

The inventory turns calculation, it is worth repeating, is a key way for a company to manage inventory.

The calculation, which is a relatively simple one if you have the required information at hand, is the annual cost of goods (what was paid for the goods) divided by the average inventory level.

It is often done at the beginning and middle of each month, although some companies do it on a daily basis.

What It Really Means

A lower turnover rate may point to possible problems that require prompt consideration, such as overstocking, product defects, obsolete items or faulty marketing.

A higher turnover rate may point to insufficient inventory

Inventory accounts for a major chunk of a company’s working capital

Consequently, if there is a low turnover, a company is tying up a significant portion of its cash in an asset that may not be easy to liquidate in the short-term.

Decision making regarding the ideal inventory turns for a company will take into account the average gross margin that comes from the sale of the products. The higher the gross margin, the lower the inventory turns can be. On the flip side of the coin, a lower gross margin calls for a higher turnover.

However, there is a slight twist to this logic. The annual turnover rate does not suggest that every item in stock will turn over at the same rate. Some go faster than others and some may eventually become dead stock.

A very well-managed company may even calculate turnover for every product it possesses. This will provide some clarity as to the company’s return on investment.

Remember, while inventory turns calculation is just one tool of measurement, when coupled with other measurements it helps paint an accurate picture of where the company is heading.

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