How does the inventory turnover ratio impact average inventory?
The inventory turnover ratio is calculated as cost of goods sold (or cost of sales) divided by average inventory.
The inventory turnover ratio measures how many times a company flips their inventory each year (i.e. convert from raw materials to finished goods to sold). Average inventory and the inventory turnover ratio have an inverse relationship.
This means that if the company can increase their inventory turnover ratio, the average inventory in their warehouse decreases. Reducing average inventory in the warehouse should be a priority for any company as it increases free cash flow.
The example below illustrates how an increase in the inventory turnover ratio from 8 times per year to 10 times per year reduces average inventory by $3,313. This means that the company can use the $3,313 for other aspects of the business and not have that money sitting in inventory in the warehouse.
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