Explain inventory turnover ratio, Accounting Basics

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Q. Explain Inventory turnover ratio?

An important ratio for managers, investors, and creditors to consider when analyzing a company's inventory is the inventory turnover ratio. This ratio tests whether a company is generating a adequate volume of business based on its inventory.

To calculate the inventory turnover ratio:

Inventory turnover ratio=Cost of goods sold/Average inventory

Inventory turnover measures the competence of the firm in managing and selling inventory therefore it gauges the liquidity of the firm's inventory. A high inventory turnover is usually a sign of efficient inventory management and profit for the firm the faster inventory sells the less time funds are tied up in inventory. A comparatively low turnover could be the result of a company carrying too much inventory or stocking inventory that is slow-moving, obsolete or inferior.

In assessing inventory turnover analysts as well consider the type of industry. When making comparisons among firms they check the cost-flow assumption used to value inventory as well as cost of products sold.

Abercrombie & Fitch reported the successive financial data for 2000 in thousands

Cost of goods sold....... $728,229

Beginning inventory...... 75,262

Ending inventory........ 120,997

Their inventory turnover is:

USD 728,229/[(USD 75,262 + USD 120,997)/2] = 7.4 times

You must now understand the importance of taking an accurate physical inventory as well as knowing how to value this inventory. In the next section you will learn the general principles of internal control and how to control cash. Cash is one of a company's most vital and mobile assets.


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