Financial ratios are very useful tools for comparing the financial performance of a company across time as well as against the performance of its peer companies or industry.
In relation to inventory management, there are specific ratios which can assist in determining how effective a company is in managing its inventories relative to other companies. Due to differences in inventory methods, one has to be very careful when making this comparison so as not to draw wrong conclusions.
The inventory turnover, days of inventory on hand, and gross profit margin are the three most common financial ratios used to evaluate the efficiency and effectiveness of a company’s inventory management.
Inventory Turnover Ratio
The inventory turnover ratio measures the number of times during a year that a company sells or turns over its inventory. A higher turnover ratio indicates that inventory is sold more often during the year.
Days of Inventory on Hand
Days of inventory on hand is calculated as days in the period divided by inventory turnover. The two ratios are therefore inversely related. Notwithstanding, it is possible for inventory turnover to be calculated using average inventory in the year, while days of inventory on hand is based on the ending inventory amount. Generally speaking, the inventory turnover and the number of days of inventory on hand should be benchmarked against industry norms and compared across years.
A high inventory turnover ratio and a low number of days of inventory on hand are indicative of highly effective inventory management. Alternatively, a high inventory turnover ratio and a low number of days of inventory on hand could indicate that the company does not carry an adequate amount of inventory or that the company has written down inventory values. To get an accurate explanation, an analyst could compare the company’s inventory turnover and sales growth rate with those of the industry and review financial statement disclosures.
A low inventory turnover ratio and a high number of days of inventory on hand relative to industry norms are indicative of slow-moving or obsolete inventory. Once again, to get an accurate explanation, an analyst could compare the company’s sales growth rate with those of the industry and review financial statement disclosures.
Gross Profit Margin
The gross profit margin indicates the percentage of sales that are contributed to net income as opposed to covering the cost of sales. Companies which are in highly competitive industries generally have lower gross profit margins than companies in industries which have fewer competitors.
Inventory Method Considerations
When comparing companies, the differences in the choice of inventory valuation method may significantly affect the comparability of financial ratios between companies. As a result, a restatement from the LIFO method to the FIFO method is critical for making a valid comparison with companies using a method other than the LIFO method.
The following information is provided for company’s XYZ and ABC:
The inventory turnover ratio for both companies is closest to:
A. Company XYZ (LIFO): 4.75; Company ABC (FIFO): 3.46
B. Company XYZ (LIFO): 4.81; Company ABC (FIFO): 3.54
C. Company XYZ (LIFO): 3.46; Company ABC (FIFO): 4.75
The correct answer is A. Inventory turnover ratio = cost of goods sold/average inventory = 1,252,000/263,579 = 4.75 for company XYZ, and 1,064,200/308,000 = 3.46 for company ABC.
Decon Transports reported the following information in its financial reports for the last 6 month:
Beginning inventory: $50,000
Ending Inventory: $30,000
Cost of goods sold: $80,000
The company’s number of days of inventory is closest to:
The correct answer is B.
Inventory turnover ratio = Cost of goods sold/Average inventory
80,000/[(50,000+30,000)/2] = 2
Number of days of inventory = Number of days within the period/Inventory turnover ratio
= (30days*6month)/2= 90
Reading 28 LOS 28k:
Calculate and compare ratios of companies, including companies that use different inventory methods