Inventory Turnover

Inventory turnover measures how often each year a business sells and replaces its inventory. Bigger is better.

Main types of inventory

• Raw Materials & Components
• Work in progress
• Finished goods

Calculating inventory turnover

Inventory Turnover = Cost of Sales / Inventories

So if cost of sales was £500,000 and inventories was £50,000 then inventory turnover would be 10 (times per year).

Cost of sales from income statement Inventories from balance sheet

Receivables

Receivables (days) = Trade receivables / revenue (sales) x 365

Payables

Payables (days) = Trade payables / cost of sales x 365

Evaluating inventory turnover

• Varies between industries
• Holding more inventory may improve customer service
• Seasonal fluctuations in demand during the year may not be reflected in the calculations
• Inventory turnover is not relevant to most service businesses

How can inventory turnover be increased?

• Sell-off or dispose of slow-moving or obsolete inventory
• Introduce lean production techniques to reduce amounts of inventory held
• Rationalise the product range made or sold
• Negotiate “sale or return” arrangements with suppliers – so inventory can be returned if it does not sell

Limitations of Ratio Analysis

• One data set is not enough
• Unknown reliability of data
  • Window dressing
• Based on the past
• Comparability

Why might ratio data not be entirely reliable?

• Financial information involves making subjective judgements
• Different businesses have different accounting policies
• Potential for manipulation of accounting information (window dressing)

What ratios don’t show

• Competitive advantages (brand strength etc)
• Quality
• Ethical reputation
• Future prospects
• Changes in the external environment

Ratios Summary

• Very useful analytical tools
• Widely used and understood
• Identify issues but don’t solve problems
• Part of a range of indicators of business problems

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Following is work not notes

Practice Exercise 11

• Which ratio would be best for:

1. how effective inventory control is → Inventory Turnover
2. whether shareholders are likely to be happy with their share of the profit: ROCE
3. whether a business is likely to be able to avoid a liquidity problem in the short term if it can convert all of its liquid assets into cash: Current Ratio
4. how effective a business is in turning its raw materials or finished products into products with higher value: Gross Profit Margin
5. whether a business is likely to experience a liquidity problem in the long term: Gearing
6. how successful the business is in using its capital to generate profit: ROCE
7. how quickly a business is receiving money from customers who buy its good on credit: Receivables days
8. whether a business is successful in generating profit from its usual business activities, in comparison to the sales revenue that it receives: Operating Profit Margin
9. whether suppliers are providing the business with good credit terms: Gearing
10. how vulnerable the business might be if there is a dramatic increase in interest rates: Gearing

Practice Exercise 12

Planned responses only.

1. Explain two factors that may cause the information used in a firm’s ratio analysis to be unreliable.

   Window dressing is capable of masking the true financial situation of the business, so if used correctly a firm may be able to appear as though it is in a better situation than it actually is.

   Financial reports are also historical, which means they only reflect what the situation of the business was, not what it is currently. This makes them ineffective at identifying any short term trends or changes in the business.

2. State two types of comparison used in ratio analysis

   • Direct comparisons of ratios – works within an industry
   • Historical comparisons – look at trends between companies

3. Explain three reasons why comparisons of ratios may provide misleading results.

   • It is possible to manipulate figures by using ratios that place a business in a more favourable light (window dressing)
     • The business may choose to try and show their best side in financial reports to increase the chance of people investing in the business and to protect themselves from fear amongst shareholders.

• Not all ratios are always relevant to all situations
  • It makes sense for specific businesses and industries to use certain formulae, however for other businesses that formulae may not provide any valuable insight into the state of the business.
• Data may contain inaccuracies or be interpreted wrong
  • It is possible that a figure was written down wrong or a formula was followed improperly, leading to untrue statistics being used in a financial report. Whilst this is unlikely as these reports should be checked, it is still definitely a possibility.

4. Identify two external factors that can affect company performance. Using a particular ratio, show how it might be affected by the two external factors that you have identified.

   • Inflation

   • A change in foreign policy (tariffs/customs)

   • Inventory turnover may reduce if there are frequent delays at customs

   • If inflation rose, then people might have to ration their usage of your products

5. Analyse how changes in a car manufacturer’s corporate objectives might influence the ways in which a car manufacturer uses ratio analysis.

   If a corporate objective goes from being breaking even to maximising profit, then switching from current ratio to receivable days might have a positive impact on the business.

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