The inventory turnover ratio is one of the most important financial ratios.
Inventory Turnover = Sales / Inventory or Total Cost of Goods Sold / Average Inventory
Interpretation: Generally, a high Inventory Turnover Ratio means that the company is efficiently managing and selling its inventory. The faster a company sells, the less funds the company has tied up. If a company has a low inventory turnover ratio, there is a risk they are holding obsolete inventory which is difficult to sell. This may eat in to a company’s profit[1].
The question is, why does it mean that a high Inventory Turnover Ratio shows that a company is efficiently managing its inventory?
- The lower the inventory, the less the company spends on rent, utilities and storage.
- Items that turn over more quickly increase responsiveness to change in customer requirements.
- Stocks are turning over at a high rate, and new products are appearing in stores, rather than just sitting in the warehouse, which means that the company is generating more profit.
Zara and Dell are such companies that maintain a high inventory turnover ratio and a large part of their success has to do with it. The figure (shows the average number of days that stocks are held in the warehouse before they move to retail stores) below shows how Zara has maintained itself to be a company which has one of the fewest “inventory days”.
[1] http://www.investopedia.com/terms/i/inventoryturnover.asp