Always keep in mind that a company’s sole purpose is to generate profits and convert these profits into actual cash received. Therefore, a company with huge inventories, by itself, is meaningless. It is in the ability of the company to sell these inventories to its’ customers and convert them to actual CASH that is the crucial to the stability and profitability of a company. The Inventory Turn ratio is a key performance indicator of the company's ability to do so. The components of the Inventory Turn ratio are:
Cost of Goods Sold (COGS)
Cost of goods sold comprises of all direct costs attributable to the production of the goods sold by a company.
Inventories usually consists of raw and packaging materials, work-in-progress, finished goods and spare parts.
Significance of the Inventory Turn ratio
The Inventory Turn ratio allows us to analyze how long it takes for the company to convert its’ inventories into sales to its' customers. This inventory turnover will vary widely based on the industry the company is in. A company selling large, highly customized machineries will have a longer inventory turn compared to one in the Fast Moving Consumer Goods (FMCG) industry.
It is more significant to compare a company’s inventory turn ratio over a period of time or compare the inventory turn of a company with other companies in a similar industry. A short inventory turn (e.g. less that 60 days) is a favorable indicator, as it means the company is holding just sufficient stocks to meet customer demands and less cash is tied up in inventories.
On the other hand, if a company’s inventory turn ratio has increased dramatically over time (e.g. to 120 days currently, from 60 days in prior years), this means the company may be facing problems. A high ratio may indicate that its’ inventories are non-saleable or is facing an overstocking situation. This leads to increase in insurance costs, warehousing costs to house the inventories and possibility of obsolete and damaged stocks. The company may face liquidity issues as too much of its’ operating cash are now tied up in the increasing pile of inventories in its’ warehouses.
Nestlé’s inventory turn ratio indicates a significant deterioration of over 26.8% as compared to last year. Its current inventory turn is now 71 days as compared to 56 days in 2006. This indicates that Nestlé’ is unable to convert its’ inventories to sales as efficiently as in prior years.
Revenues have only increased by 4.29%, yet inventories have increased significantly by 35%. This disproportionate increase in inventories as compared to revenue is highlighted by the deterioration in the inventory turn ratio. A substantial amount of Nestlé’s cash is tied up in its inventories, reducing its operating cash inflow for the year. Management must review this situation closely to ensure that the inventory is managed to prevent an overstock situation.
A high inventory turn ratio (especially compared to previous years or companies’ in a similar industry) is undesirable. This means that the company is unable to convert its’ stocks into sales to customers as efficiently as before. Consequently, additional insurance, warehousing and financing costs are incurred to maintain the higher level of inventories. Pay a close watch to the inventory turn ratio as it is a good key performance indicator of the Supply Chain Management function of a company.