![]() ![]() Using the annual sales for the numerator: ![]() Both companies sell 12,000,000 widgets annually, hold 1,000,000 widgets in inventory, and the cost of goods for the widgets is $1 for both companies. Rural Widget Seller sells widgets for $2 in its low priced market. Big City Widget Seller sells widgets for $4 in its high priced market. There are 2 companies selling widgets in 2 locations. In seasonal businesses, where the amount of inventory varies widely throughout the year, the average inventory cost is used in the denominator.Įxample 1: Calculating Inventory Turnover Using the cost of goods sold in the numerator is a more accurate indicator of inventory turnover, allowing a more direct comparison with other companies, since different companies would have different markups to the sale price, which would overstate the actual inventory turnover. The best measure of inventory utilization is the inventory turnover ratio (aka inventory utilization ratio), which is the total annual sales or the cost of goods sold divided by the cost of inventory. A higher inventory turnover ratio indicates more effective cash management and reduces the incidence of inventory obsolescence. Generally, the average collection period should not exceed the credit terms that the company extends to its customers.įor a company to be profitable, it must be able to manage its inventory, because it is money invested that does not earn a return until the product is sold. Closely related to the accounts receivable turnover rate is the average collection period in days, equal to 365 days divided by the accounts receivable turnover:Īnalysts frequently use the average collection period to measure the effectiveness of a company's ability to collect payments from its credit customers. ![]()
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