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10.5 Examine the Efficiency of Inventory Management Using Financial Ratios

Inventory Management Ratios​

Financial ratios help measure how efficiently a business manages its inventory. Key ratios include:

  1. Inventory Turnover Ratio
  2. Days Sales in Inventory

Inventory Turnover Ratio​

Formula: Inventory Turnover = Cost of Goods Sold ÷ Average Inventory

What it Measures:

  • How many times inventory is sold and replaced during the period
  • Higher ratio = faster turnover = better

Calculation:

  • Cost of Goods Sold: From income statement
  • Average Inventory: (Beginning Inventory + Ending Inventory) ÷ 2

Example:

  • Cost of Goods Sold: €120,000
  • Beginning Inventory: €20,000
  • Ending Inventory: €30,000
  • Average Inventory: (€20,000 + €30,000) ÷ 2 = €25,000
  • Turnover: €120,000 ÷ €25,000 = 4.8 times

Interpretation:

  • Inventory is sold and replaced 4.8 times per year
  • Good turnover (depends on industry)

Days Sales in Inventory​

Formula: Days Sales in Inventory = 365 Days ÷ Inventory Turnover

Or: Days Sales in Inventory = (Average Inventory ÷ Cost of Goods Sold) × 365

What it Measures:

  • Average number of days inventory is held before sale
  • Lower number = faster sale = better

Example:

  • Inventory Turnover: 4.8 times
  • Days Sales in Inventory: 365 ÷ 4.8 = 76 days

Interpretation:

  • Inventory is held an average of 76 days before sale
  • Reasonable for many businesses

Industry Benchmarks​

Typical Turnover Rates:

  • Grocery stores: 10-15 times per year
  • Retail clothing: 4-6 times per year
  • Restaurants: 20-30 times per year (food inventory)
  • Electronics: 3-5 times per year
  • Furniture: 2-4 times per year

Typical Days in Inventory:

  • Grocery: 24-36 days
  • Retail: 60-90 days
  • Restaurants: 12-18 days
  • Electronics: 73-122 days

Improving Inventory Management​

Strategies to Improve:

  1. Inventory Levels

    • Reduce excess inventory
    • Just-in-time purchasing
    • Better demand forecasting

  2. Purchasing

    • Buy in appropriate quantities
    • Negotiate better terms
    • Reduce lead times

  3. Sales

    • Increase sales volume
    • Reduce slow-moving items
    • Better product mix

  4. Inventory Control

    • Regular counts
    • Better tracking
    • Reduce theft and spoilage

Luxembourg Considerations​

Inventory Management:

  • Important for cash flow
  • Affects profitability
  • Must balance levels
  • Consider VAT implications
  • Must comply with regulations

Luxembourg Compliance Note​

Inventory management in Luxembourg:

  • Must maintain accurate records
  • Must conduct regular counts
  • Must value inventory properly
  • Must comply with PCN requirements
  • Must support inventory values
  • Must handle VAT correctly

Think It Through​

A business has an inventory turnover of 2 times per year. What does this indicate, and what actions should be taken?