The inventory turnover ratio is the most important ratio used by providers of working capital finance.
Inventory turnover ratio reveals how well inventory is being managed. In other words, it indicates the number of times in a year that the inventory of a company is sold and converted into cash. The more times that inventory is turned into cash in a given operating cycle, the greater the profits are. Inventory turnover ratio is calculated as follows:
Inventory Turnover Ratio = Net Sales / Average Inventory at Cost
Managers usually try to picture a high inventory turnover ratio, since a higher ratio indicates that the firm is selling its inventory more quickly. An inventory turnover ratio of 4.75 times, or 475 percent, means that the firm sold its inventory stock 4.5 times during the given operating cycle.
As inventories tend to change over the year, it is appropriate to use the average of opening and closing inventories. For the most part the higher the ratio the better, since inventory is being sold more quickly. However, this is not always true as a high inventory turnover may be due to a low level of inventory. This can result in missed sales if customers request products that are unavailable, which can strain customer relations and hinder potential profit margins.