Businesses who carry inventory analyze their inventory balance on a regular basis. Merchandising businesses and manufacturing companies rely on their inventory to serve their customers, either through reselling purchased merchandise or by manufacturing products for customers. These companies calculate ratios, such as the inventory turnover ratio, to determine whether the level of inventory they carry benefits the business. The inventory turnover ratio provides several significant pieces of information.
Use the beginning and ending inventory balance and the number of days in the year to calculate the inventory turnover ratio. Review the asset section of the current balance sheet to determine the ending inventory balance. Review the asset section of the previous balance sheet to determine the beginning inventory balance. Calculate the average inventory value by adding the two balances together and dividing them by two. Divide this number by 365 to determine the inventory turnover ratio.
Frequency of Sales
Companies want to experience frequent sales. The more sales it records, the higher the profit for the company's owners. The inventory turnover ratio provides information regarding the frequency of sales that occur at the company. The inventory turnover ratio communicates the number of times the company sells out the total inventory and replaces it throughout the year. The higher the ratio, the more frequently the company records sales.
Risk of Obsolescence
Companies who carry inventory risk the inventory becoming obsolete before selling it. Obsolete inventory becomes unsalable to customers and represents a loss to the company. This risk is higher in some industries, such as technology, and lower in others. As the company's inventory sales increase, its risk of inventory obsolescence decreases. As the inventory turnover ratio increases, it reduces the risk of inventory obsolescence.
Companies who rely on using or selling inventory to meet customer demands suffer when they lack the merchandise to ship to the customer. A customer who cannot receive an order from the company due to an inventory shortage may shop from competitors instead. The inventory turnover ratio provides information regarding the risk of potential shortages. A higher inventory turnover ratio indicates a higher level of sales. As the company experiences higher sales, it runs the risk of selling out of inventory before replacing it.
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