Inventory Turnover Ratio interpretation
Inventory Turnover Ratio is one of the efficiency ratios and measures the number of times, on average, the inventory is sold and replaced during the fiscal year. Inventory Turnover Ratio formula is:
Inventory Turnover Ratio measures company's efficiency in turning its inventory into sales. Its purpose is to measure the liquidity of the inventory.
Inventory Turnover Ratio is figured as "turnover times". Average inventory should be used for inventory level to minimize the effect of seasonality.
This ratio should be compared against industry averages.
A low inventory turnover ratio is a signal of inefficiency, since inventory usually has a rate of return of zero. It also implies either poor sales or excess inventory. A low turnover rate can indicate poor liquidity, possible overstocking, and obsolescence, but it may also reflect a planned inventory buildup in the case of material shortages or in anticipation of rapidly rising prices.
A high inventory turnover ratio implies either strong sales or ineffective buying (the company buys too often in small quantities, therefore the buying price is higher).A high inventory turnover ratio can indicate better liquidity, but it can also indicate a shortage or inadequate inventory levels, which may lead to a loss in business.
High inventory levels are usual unhealthy because they represent an investment with a rate of return of zero. It also opens the company up to trouble if the prices begin to fall.
A good rule of thumb is that if inventory turnover ratio multiply by gross profit margin (in percentage) is 100 percent or higher, then the average inventory is not too high.
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