10.5 Examine the Efficiency of Inventory Management Using Financial Ratios - Principles of Accounting, Volume 1: Financial Accounting

Inventory is a large investment for many companies so it is important that this asset be managed wisely. Too little inventory means lost sales opportunities, whereas too much inventory means unproductive investment of resources as well as extra costs related to storage, care, and protection of the inventory. Ratio analysis is used to measure how well management is doing at maintaining just the right amount of inventory for the needs of their particular business.

Once calculated, these ratios should be compared to previous years’ ratios for the company, direct competitors’ ratios, industry ratios, and other industries’ ratios. The insights gained from the ratio analysis should be used to augment analysis of the general strength and stability of the company, with the full data available in the annual report, including financial statements and notes to the financial statement.

Fundamentals of Inventory Ratios

Inventory ratio analysis relates to how well the inventory is being managed. Two ratios can be used to assess how efficiently management is handling inventory. The first ratio, inventory turnover, measures the number of times an average quantity of inventory was bought and sold during the period. The second ratio, number of days’ sales in inventory, measures how many days it takes to complete the cycle between buying and selling inventory.

Calculating and Interpreting the Inventory Turnover Ratio

Inventory turnover ratio is computed by dividing cost of goods sold by average inventory. The ratio measures the number of times inventory rotated through the sales cycle for the period. Let’s review how this works for The Spy Who Loves You dataset. This example scenario relates to the FIFO periodic cost allocation, using those previously calculated values for year 1 cost of goods sold, beginning inventory, and ending inventory, and assuming a 10% increase in inventory activity for year 2, as shown in Figure 10.24.

Balance Sheet Year 1 has: Beginning Inventory $3,150 plus Purchases 13,005 equals Goods Available for Sale 16,155 minus Ending Inventory 8,955. This equals the Cost of Goods Sold of $7,200 which would be on the Income Statement for Year 1. Balance Sheet Year 2 has: Beginning Inventory $8,955 plus Purchases 8,816 equals Goods Available for Sale 17,771 minus Ending Inventory 9,851. This equals the Cost of Goods Sold of $7,920 which would be on the Income Statement for Year 2. Note: Year 2 values for Sales, Goods Available, and Ending Inventory were estimated, based on 110 percent of Year 1’s amounts.

Figure 10.24 Excerpts from Financial Statements of The Spy Who Loves You Company. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

The inventory turnover ratio is calculated by dividing cost of goods sold by average inventory. The result for the Spy Who Loves You Company indicates that the inventory cycled through the sales cycle 1.19 times in year 1, and 0.84 times in year 2.

Inventory Turnover Ratio calculation for year 1 and 2: Year 1: Cost of Goods Sold $7,200 divided by Average Inventory* 6,053 equals Inventory Turnover of 1.19. Year 2: Cost of Goods Sold $7,920 divided by Average Inventory* 9,403 equals Inventory Turnover of 0.84. *Average Inventory Year 1 equals (3,150 plus 8,955) divided by 2; Average Inventory Year 2 equals (8,955 plus 9,851) divided by 2.

The fact that the year 2 inventory turnover ratio is lower than the year 1 ratio is not a positive trend. This result would alert management that the inventory balance might be too high to be practical for this volume of sales. Comparison should also be made to competitor and industry ratios, while consideration should also be given to other factors affecting the company’s financial health as well as the strength of the overall market economy.

Calculating and Interpreting the Days’ Sales in Inventory Ratio

Number of days’ sales in inventory ratio is computed by dividing average merchandise inventory by the average daily cost of goods sold. The ratio measures the number of days it would take to clear the remaining inventory. Let’s review this using The Spy Who Loves You dataset. The example scenario relates to the FIFO periodic cost allocation, using those previously calculated values for year 1 cost of goods sold, beginning inventory, and ending inventory, and assuming a 10% increase in inventory activity for year 2, as in Figure 10.25.

Figure 10.25 Excerpts from Financial Statements of The Spy Who Loves You Company. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

The number of days’ sales in inventory ratio is calculated by dividing average inventory by average daily cost of goods sold. The result for the Spy Who Loves You indicates that it would take about 307 days to clear the average inventory held in year 1 and about 433 days to clear the average inventory held in year 2.

Table showing Number of Day’s Sales in Inventory Ratio calculation: Year 1: Average Inventory* 6,053 divided by Average Daily Cost of Goods Sold** 19.73 equals Days’ Sales in Inventory $306.79. Year 2: Average Inventory* 9,403 divided by Average Daily Cost of Goods Sold** 21.70 equals Days’ Sales in Inventory $433.32. *Average Inventory Year 1 equals (3,150 plus 8,955) divided by 2; Average Inventory Year 2 equals (8,955 plus 9,851) divided by 2. **Average Daily Cost of Goods Sold Year 1 equals (7,200 divided by 365); Average Daily Cost of Goods Sold Year 2 equals (7,920 divided by 365).

Year 2’s number of days’ sales in inventory ratio increased over year 1’s ratio results, indicating an unfavorable change. This result would alert management that it is taking much too long to sell the inventory, so reduction in the inventory balance might be appropriate, or as an alternative, increased sales efforts could turn the ratio toward a more positive trend. This ratio is useful to identify cases of obsolescence, which is especially prevalent in an evolving market, such as the technology sector of the economy. As with any ratio, comparison should also be made to competitor and industry ratios, while consideration should also be given to other factors affecting the company’s financial health, as well as to the strength of the overall market economy.

Link to Learning

Check out Investopedia for help with calculation and analysis of ratios and their discussion about the inventory turnover ratio to learn more.