Financial Accounting

Learn the toughest concepts covered in your Financial Accounting class with step-by-step video tutorials and practice problems.

14. Financial Statement Analysis

Ratios: Inventory Turnover



Ratios: Inventory Turnover

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Alright now let's discuss another ratio. The inventory turnover ratio. So the inventory turnover ratio, this is going to relate the amount of cost of goods sold, cost of goods sold to average inventory levels. Right. So we'll discuss this in a little more detail. Um But the inventory turnover ratio, this is a really common efficiency ratio that you study in this class. Okay. So we're trying to see how efficiently we use our inventory. Remember when we have inventory, it costs us money to store whatever boxes. If we sell t shirts we've got boxes of t shirts sitting in a warehouse. Well that warehouse costs us money. Right? So we want to basically manage that as well as possible. So let's look how we calculate this ratio right here. Okay, inventory turnover ratio. Well it equals cost of goods sold divided by average inventory. Okay, In a lot of ratios we use this average balance idea. Okay, and the average balance, we're always going to calculate it the same way we're gonna take the beginning balance in that account plus the ending balance in that account. So we're gonna do that first, we're gonna add those together and then we're gonna divide by two. Just like you see up here, right? The average inventory, that's the beginning inventory plus the ending inventory divided by two. Right? So that's how we're always going to calculate the average. Now sometimes when they give you the inventory turnover ratio, they might just give you one number for inventory, they may not say beginning inventory and ending inventory. Well if they just give you one number, well that's gonna be your average, that's just gonna be what you use for inventory. Okay, So in this case, cost of goods sold over average infant, that's our inventory turnover. Okay, So what does this really tell us? It tells us how many times we turned our inventory into cogs. So if you imagine we're gonna have some average level of inventory, say there's $10,000 worth of t shirts that sit in our warehouse at any given time, Right? But that $10,000 of t shirts, Well, it doesn't just sit there and that's always there, right? We're selling T shirts were buying more t shirts. So it's kind of a cycle, Right? So if you think about it, we're gonna have some number for cost of goods sold. And it's related to inventory because every time we make a sale right, it comes out of inventory. The cost of goods sold come out of inventory. Well, we're gonna have this average balance that we keep in our inventory, but we're gonna be selling it. So we would expect that we would turn that inventory into cogs, hopefully a few times, right? And be more efficient. The lower amount of inventory we can keep and just sell cogs and and just be making lots of sales. Right? So the idea here is how efficiently are we using those inventory levels? Think about it, wouldn't it be most efficient if we didn't have to hold any t shirts at all? If our inventory was zero but we were able to just make tons and tons of sales. So every time we needed a t shirt instead of going to our warehouse and have all these costs to maintain a warehouse. Well that t shirt just went straight to the customer from the factory that prints them or whatever it is. Well that would be very efficient because we don't have any warehouse costs at that point. But it's still efficient to keep a very manageable amount of inventory. Maybe we can keep just the right amount of inventory, Just a small amount of inventory that we can keep turning without ever running out. Right? If we keep too little inventory, maybe we run into the problem that we get orders from customers and we can't fill them because we don't have enough inventory. So we want to be able to manage that inventory properly so that we were able to keep up with our sales but also maintain our warehouse costs at a reasonable level. So that's what the inventory turnover is trying to tell us here. Okay, so how do we compare our inventory turnover turnover like a lot of ratios while we use benchmarking? We wanna be able to compare our inventory turnover to other companies in our industry? How well are we managing our inventory compared to our competitors, right? If it takes us huge warehouses to manage our t shirt business and we've got to have thousands of boxes of t shirts just sitting there costing us money and there's another company that hey, they just print it and send it to the customer right away. Well they're gonna have a lot more efficient management of their inventory. Right? So we want to benchmark against our competitors and see if we're turning our inventory faster, Right? So what we want is high inventory turnovers. Higher inventory turnover ratios means we're being more efficient with our inventory. Right? So that's basically how we analyze inventory turnover. Why don't we go ahead and move into this example and see how we calculate an inventory turnover ratio? Let's do it right now. So this first question right here, X. Y. Z. Company had net sales of 500,000 and cogs of 320,000. If the beginning balance of inventory was 60,000 and the ending balance in inventory was 100,000. What is the inventory turnover ratio? So notice they talked to us about net sales in this question. And this is a classic way that they try and trip you up with inventory turnover as they talk about net sales. But remember when we when we're doing inventory turnover, when we sell inventory? Well, our, our sales revenue is related to the cash we received from customers right? The selling price of the good. But inventory and cogs that relates to what we paid for the goods. So inventory is related to cogs where sales revenue is more related to the cash we received from customer the selling price of the good. Okay so they're generally gonna try and trick you like this and throw in a net sales number. But remember inventory turnover we want to use cogs here. Okay so that's our good number. Cogs 320,000. That's gonna be our numerator. What about our denominator? Right. We have to calculate that average inventory balance. So in this case they gave us two numbers right? They gave us a beginning and ending balance. So we have to calculate an average. So let's go ahead and calculate that. Let's do our average inventory first. Right? So it gave us a beginning balance of inventory with 60,000. Our ending balance of inventory was 100,000. Well the average inventory is gonna be those two numbers divided by two right beginning balance plus ending balance divided by two. That's our average balance. So the numerator is 160,000 divided by two is going to give us 80,000 as our average inventory balance. Right? So we're not done yet. Now we got to actually calculate our inventory turnover. So inventory turnover, whoops turnover. Remember that's gonna be cogs over the average inventory average Inventory. Right? So we've got those numbers ready. We've got our cogs of 320,000. We've got our average inventory of 80,000. So we've got an inventory turnover of four in this case, right four times. So that means during the year we were able to turn our average inventory balance this 80,000 that's usually sitting in our warehouse. Well, we turned it into $320,000 worth of sales. We were able to turn that average inventory into four times the amount of sales and cogs. Right. Hopefully that makes sense to you right there. And that is our answer here. So C 4.0. That is our inventory turnover turnover ratios are usually a little more complicated to understand the logic. But if you if you think about it like that, right, How many times we turn that average inventory, what we have sitting in our warehouse? How many times are we able to flip that and turn it into cogs? Make sales and turn that inventory, Get it out of the warehouse. So basically everything that was sitting in the warehouse was able to move out of the warehouse four times during the year. Cool. Let's go ahead and move on to this practice problem where you guys get to try and solve inventory turnover

ABC Company had $200,000 in Net Sales and Gross Profit of $80,000. If Inventory had a balance of $60,000, what is the Inventory Turnover ratio?