Inventory Management Analysis
In this lesson, we will learn how to calculate and interpret inventory ratios and compare inventory management performance across different years of the business, and with other businesses.
Related Lessons:
Purpose of Inventory Management
Inventory management is important as inventory forms a large part of a trading business’ current asset. Since inventory can only be converted to cash after being sold, therefore, it is considered not liquid. As such, inventory holding directly affects a business’ liquidity.
Efficient inventory management means the business is able to:
- maintaining the right level of inventory on hand to meet customer demand
- avoid out-of-stock situations which results in loss of revenue
Calculating Inventory Ratios
There two inventory ratios that are used to help a business measures its efficiency in managing inventory.
A) Rate of Inventory Turnover
This ratio measures the rate at which a business sells and replenishes its inventory during the financial year.
To calculate, we take Cost of Sales divided by Average Inventory. This gives us the number of times inventory is replenished during the financial year.
Cost of sales / Average Inventory = x times
Average Inventory is calculated by taking Inventory at the beginning of the financial year plus Inventory at the end of the financial year, divided by 2.
(Beginning Inventory + Ending Inventory) / 2
B) Day Sales in Inventory
This ratio measures the number of days a business takes to sell its inventory during the financial year. This helps the business determine its efficiency in selling its goods.
To calculate, we take Average Inventory divided by Cost sales and multiply the answer by 365 days. This gives us the number of days the business takes to sell its goods.
(Average Inventory / Cost of sales) x 365 days = x days
Interpreting Inventory Ratios
A low inventory turnover ratio is usually accompanied by a high days’ sales in inventory ratio. This indicates that the business is taking a longer time to sell its goods, so it needs to replenish inventory less frequently.
Possible causes include:
- Inefficiency in selling
- Holding low demand or obsolete products
This results in cash being tied up thereby causing quick ratio to decline. Profit may also be reduced due to increase in storage and handling cost, obsolescence or theft.
To improve, the business may increase sales by:
- Reducing selling price
- Gives trade discounts or special promotions
- Advertise to raise brand awareness
The business may also reduce inventory on hand by having clearance sales for older stocks.
Of course, a low inventory turnover may not always point to an inventory management problem in the business. A low ratio could also be due to the business:
- Buying large amount of goods due to a major discount
- Stocking up for an upcoming event
A high inventory turnover ratio with a low days’ sales in inventory ratio means that the business is:
- Efficient in selling
- Selling the right product that consumer wants
Likewise, it may also signify a problem in managing its inventory. The business is buying insufficient stocks leading to frequent sell out. This results in lost sales and money since it is unable to meet customer demand.
Frequent replenishment can lead to high cost of purchase due to delivery cost and possible lost on trade discount. This causes profit to fall.