10 Inventory

Inventory Ratios: Evaluating Inventory Management

Readers of financial statements may be interested in how long a company holds its inventory before selling it. I mean, a company pays cash for inventory and then that cash is unavailable until the inventory is sold, so cash is tied up in inventory. Best practice is to have enough inventory on hand to satisfy customer demand, but no more than is needed.

I’d like to introduce you to two inventory ratios: days in inventory and inventory turnover. These ratios measure the same thing but in a different way. Inventory turnover describes how many times inventory is completely refreshed during the period:

We want to hold inventory for as short a period as possible while still satisfying customer demand. So in general a higher inventory turnover is better. But this ratio is abstract and not super easy to interpret. Luckily there’s a ratio that makes inventory turnover more understandable. Average days in inventory describes how long inventory tends to hang around in storage before it is sold.

Again, we want to minimize the time that cash tied up in inventory, so lower average days in inventory is better.

Interesting, right? Let’s look at an example and then let you try to calculate these ratios on your own.

My Turn

Busy Bees (BB) produces jars of honey. BB has some questions about their inventory and has decided to use two ratios to help them analyze how long they hold their inventory.
The ratios are inventory turnover and average days in inventory.
BB’s cost of sales for the 20X3 were $55,000, inventory of $2,000 at the end of 20X3, and an inventory of $4,000 at the end of 20X2.

Last year, in 20X2, BB’s inventory turnover was 5.2 times per year and average days in inventory was 70 days.

Calculate inventory ratios for Busy Bees. Compare this year’s results with last year.

Comparison: Inventory turnover has decreased, and average days in inventory has increased, compared to last year. This means that Busy Bee is holding inventory in their warehouse longer in 20X3 than they did in 20X2, resulting in lower inventory efficiency.

Now try on your own!

Great work! Inventory is fascinating, right?

You have valued A/R and inventory, using recoverable amount and cost. Next we will look at Property, Plant and Equipment, asking how to provide relevant information on the value of these non-current assets. Let’s go 😊