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The formula for the inventory turnover ratio measures how well a company is turning their inventory into sales. The costs associated with retaining excess inventory and not producing sales can be burdensome. If the inventory turnover ratio is too low, a company may look at their inventory to appropriate cost cutting.
The denominator of the formula, inventory, is an average inventory for the period being analyzed. If monthly sales are used in the numerator of the formula, then the monthly average of inventory should be used.
One key note with the inventory turnover ratio is that the formula does not take into consideration fixed expenses. The formula provided does not consider any type of debt, but the alternative formula in the following section may be used to compare the cost of goods sold, which provides more information on a company's ability to meet its inventory costs by turning over inventory. However, the cost of goods sold method looks at only certain variable expenses and does not consider all expenses or fixed expenses.
An example of the affect this could have is a company whose sales have reduced and, in turn, decided to reduce their inventory. It is possible that the company may have maintained the same inventory turnover ratio, but they may not be able to maintain all of their debt based on sales.
Given this, it is important to note that the formula for the inventory turnover ratio is only an inventory ratio and not a liquidity ratio, such as the current ratio. It serves an individual purpose even when cost of goods sold is used.
An alternative formula used for the inventory turnover ratio is:
As stated in the previous section, the cost of goods method looks at a company's ability to meet the direct costs associated with selling their product. This should be not confused with the overall costs associated with running the business. The benefit to using this method is to eliminate gross profit from consideration.
A hypothetical example of this benefit would be two companies who operate exactly the same, yet one company has higher gross profit(sales minus Cost of Goods Sold). Both companies sale 10,000 units, have the exact same cost of goods sold for the 10,000 units, yet company A sales their product at a higher price than company B. Using sales as the numerator, both companies may appear to be equal if their inventory turnover ratios are the same. But, company A would have a lower inventory turnover ratio if costs of goods sold was used.