Advantages and Disadvantages of Inventory Turnover Ratio

Inventory turnover ratio is the financial ratio that evaluates how fast the company sells its inventory per year. It shows how many times that the inventory is sold within one accounting period. The management can use the ratio to evaluate if the inventory on hand is too low or too high compare to sales.

It tells the average number of times that the company sold its inventory. The shorter the company spends to sell the inventory is the better as they are saving on storage costs. The customer will be able to receive the fresh and new inventory. It will reduce the risk of inventory obsolete due to long storage.

The ratio tells how efficiently the company manages the inventory. The company aims to maximize the ratio as it will deduct the storage cost, holding cost, and increase sales.

Inventory Turnover Ratio Formula

\[Inventory\ Turnover\ Ratio = {Cost\ of\ Goods\ Sold \over Average\ Inventory}\]

Advantages of Inventory Turnover Ratio

• Evaluate Company’s efficiency: it is the tool that investors can use to evaluate the company’s performance. The company needs to minimize the inventory level without any impact on sale.
• Manage inventory: Store too much inventory will impact on company’s working capital. The company will face the risk of market price fluctuation and obsolete. However, too little inventory will impact to sale and customers’ waiting time. So we need to balance these two issues.
• Manage working capital: Company needs to spend money on the purchase and keeping the inventory which will help to generate a sale. If the inventory only stays in the warehouse, it means the company cash will be stuck too. The cash should be used for the other purpose which generates profit for the company.

Disadvantages of Inventory Turnover Ratio

• Can be manipulated: Management wants to keep this ratio in a good position, so they may try to deduct the inventory at the end of the year. It only uses the inventory ending balance which may not tell the whole story.
• Hide Slow-moving item: The inventory turnover ratio using the cost of goods sold and total inventory which is only overall performance. In real practice, some items may be slow-moving while the other doing good. But if we only look at the average figure, it will not tell exactly slow-moving item or good performance. Without this information, we do not know which inventory to improve.
• High ratio is not always good: the company will have high ratio when inventory balance decreases, however, it is not mean good, the company may not have enough inventory to fulfill customer orders.