The purpose of this article is to explain the characteristics of the average inventory ratio, how to calculate the ratio, and why it is utilized. For one thing, the average inventory ratio is known as a usage ratio that specifically calculates how much time it takes a firm to sell its inventory. Expressly, it points the amount of time the inventory is likely to remain unsold. So, this ratio is considered to be an efficiency ratio.
Defining the Average Inventory Ratio
The main reason why this ratio is of great importance is that it clearly points turnover changes that occur over the course of time. This facilitates the management to better comprehend purchasing and sales trends. This way, it improves the strategic approach. The goal is, of course, to diminish the inventory carrying costs.
Concurrently, thanks to this ratio, the management can determine the difference between products that are selling fast, and products that are more likely to remain stagnant, failing to bring profit to the company. Therefore, it makes sense that this ratio is an essential measure for analyzing a company’s efficiency when it comes to converting goods into sales.
Now, if the average inventory period is decreasing, this simply means that the product moves at a fast rate. Meanwhile, an increasing average inventory period highlights that selling the goods is a time-consuming process for the company.
Evidently, overseeing the amount of time the goods are likely to sit in inventory is critical for business management. Concurrently, it is fundamental for financial investors and analysts to assess this in order to prove a company’s capability of transforming inventory into cash.
The Formula of the Average Inventory Ratio
The question that naturally follows is: how does one calculate the average inventory ratio? In this view,
To begin with, you have to measure the inventory turnover rate during a specific timeframe. Most companies choose to monitor on a regular basis, while others do these calculations every six months or every year. While there is more than one way in which you can calculate this ratio, the simplest manner is by dividing the sales by the average inventory value.
After doing that, you should take the number of days (if you’re calculating for one year, that would mean 365 days) and divide by the inventory turnover. What you obtain is the average inventory period which points, on average, how many days it takes for the company to sell its goods.
It makes sense that a smaller average is more beneficial and profitable than a higher average. That’s because this means that it doesn’t take so long for the company to convert its goods into cash. The industry in which you operate matters just as much, which is why there might be certain variations depending on this aspect. Even if this ratio can be really useful, bear in mind that it doesn’t identify the cause of this problem. However, it does point out that there is an issue, requiring an in-depth analysis.