What is inventory turnover and why is it important?
Inventory turnover ratio is the cost a company pays to produce goods that have been sold in a 12-month period divided by the average inventory during that same year. It’s a popular metric because it measures a company’s ability to turn inventory, a non-cash asset, into cash. We talked about working capital as the current assets minus your current liabilities, but if your inventory just sits in the warehouse and doesn’t get sold, then the company may not have enough liquid assets to meet its obligations like paying vendors or wages and salaries.
If your inventory is not turning over, the other question to ask is have you properly valued the inventory. If you have a whole warehouse full of pet rocks from the 70s, the you might have to write down the value of your inventory because that’s never going to sell. Inventory turnover is important because it gives you an idea of kind of how much risk you have holding inventory long term.
The risk of holding aged inventory is the reason that they came up with a quick ratio, also known as the asset test ratio. It’s a financial ratio where inventory is excluded from current assets that will be compared to the company’s liability. You can have working capital ratio or working capital but the acid test ratio removes inventory. Inventory is critical to meet customers’ needs but having too much of inventory, or the wrong kind, can be bad news. It’s analogous to sending out invoices: just because you’ve sent out invoices to people doesn’t mean they’re going to pay and just because you have inventory doesn’t mean it’s going to sell.