Inventory Ratios

Once you are satisfied that a company's balance sheet accurately reports its assets and liabilities, you can determine whether these figures indicate a satisfactory financial position. In earlier sections have seen how a customer's working capital positions as well as its current and quick ratios indicate a customer's ability to meet its current obligations. This section discusses how the inventory ratios are calculated and what they reveal about a customer under review.  A company's inventory can be evaluated based on a number of fact or factors including:

• The amount of stock on hand,
• The average age of the inventory,
• Monthly sales,
• Changes in supply and demand for the product,
• The company's pricing policies,
• The effectiveness of the company's advertising,
• The skill and experience of its salespeople,
• Its desirability and marketability. 

The size, and the condition of the inventory is a major factor in evaluating the creditworthiness and financial strength of a business.  The best indication of the condition of a company's inventory is the inventory turnover ratio. This represents the number of times the value of inventory was sold each year.  This ratio is calculated by dividing the cost of goods sold by the average inventory for the period under review.

Average inventory can be calculated daily or monthly, but many creditors use this shortcut: Then take beginning and ending inventory levels from the balance sheet, add them together and divide by two to create an average inventory figure. The number of times inventory turns over in a year provides a useful indication of the organization's liquidity.

The inventory turnover ratio should be compared to past performance by the customer under review as well as compared against industry norms.  Inventory ratios are company and industry specific. The faster inventory turns over, the better from the perspective of the company under review and its creditors.  A low turnover ratio could indicate excess inventory, obsolete inventory and/or low sales, As a general rule, the higher the annualized inventory turnover, the better.

Suppose, for example, that the Jones Company reports a cost of goods sold for one year of $200,000. Its inventory on December 31, 20xx was $40,000 and its final inventory at the end of the following calendar year was $60,000. To arrive at the current year's turnover rate you would first determine the average inventory by adding these year-end figures together and dividing by 2:

But if a customer's inventory level is subject to marked seasonal fluctuations, the average should be calculated from a series of quarterly figures - or even monthly inventory numbers if available.

The credit manager would divide the cost of goods sold by the average inventory to get the turnover rate:

This hypothetical company's inventory, therefore, turned over four times in the second year. To determine whether this rate is good, satisfactory, or poor, you would have to compare it with the turnover rates of other companies in the same industry using "industry norms." These figures may be available from your industry credit group. 

If an inventory turnover rate of 4x is below average, it may mean that the company is overstocked with goods or merchandise, some of it possibly obsolete or defective. If the inventory turnover rate is average or somewhat above average, it probably means that merchandise is selling well - and that the inventory level is adequate but not excessive. If the rate is far above average it can mean either that business is well managed, or it can mean something troubling. It can mean that inventory levels of stock are dangerously low, possibly because the company is having trouble getting credit from suppliers.

Net Sales to Inventory Ratio

The turnover ratio is a penetrating indication of a company's financial position. Unfortunately, however, you frequently cannot determine a credit applicant's inventory turnover from a balance sheet. This is because a single balance sheet does not provide you with sufficient information to make the above calculations. Notice below on the annual balance sheet of the Centerville Department Store, for example, that you are given the inventory figure as of the reporting date, but that you have no way of determining the average inventory.

To address this problem, credit people often use a different calculation to evaluate the condition of a company's inventory. They determine the ratio of net sales to the single inventory figure reported on the balance sheet:

Net Sales $400,000
Inventory $ 64,000 = 6.25

This figure is commonly called the inventory turnover, but for two main reasons it is a very inaccurate indication of how many times the company's stocks were sold and replaced during the year:

1. The inventory figure is reported at the lower of cost or market while the sales figure is determined by selling price. As a result, the true turnover ratio is overstated by a proportion representing the markup of the goods (in the case of retailers and wholesalers) or representing the value added to the raw materials (in the case of manufacturers).
2. The inventory that a customer happens to have on the day of the report may be far different from the average level. In fact, customers choose their year-end it is possible, even likely that inventory is at its lowest point and the "inventory turnover" ratio is exaggerated. Nevertheless the inventory to net sales ratio is a useful tool in credit analysis. Since the merchandise markup, or the manufacturing value added to raw materials tends to be uniform within a given line, you can judge a company's relative strength if you compare its ratio with those of other companies in the line. You have to be sure that the ratios you are comparing were calculated from figures reported at the same point in the firm's accounting year.

Using industry ratios [industry norms], a net sales to inventory ratio of 6.25 places the Centerville Department Store well above the median figure in its line. This suggests that the size of the store's inventory is justified by its volume of sales. Now you should determine whether the store can adequately finance its inventory. This is revealed by the ratio of inventory to net working capital.

Inventory to Net Working Capital Ratio

According to industry norms, the median figure for the inventory to net working capital ratio among department stores is 76.6 percent The Centerville Department Store falls about midway between the median figure and the upper quartile:

Inventory                 $64,000 
Net Working Capital $100,000 = .64 = 64%

A low percentage in this ratio is a sign of strength since the lower the proportion of inventory to working capital, the less likely that it is, or will become too heavy a burden for the financial resources of the company.

If the Centerville Department Store's current liabilities amounted to $80,000 instead of $40,000, its net working capital would drop to $60,000, and the percentage of inventory to net working capital would go over 100.

Inventory                 $64,000 
Net Working Capital $60,000 = 1.07 = 107%

This would indicate "overtrading" meaning the store is undercapitalized for the volume of business it is transacting and consequently may be a poor credit risk.

Current Debt to Inventory Ratio

The third and final inventory ratio answers this question:
"To what extent does the business rely on funds from the disposal of unsold inventories to meet its debts?"

The Centerville Department Store's ratio of current debt to inventory again falls close to the median figure in its line:

Current Debt $40,000
Inventory       $64,000 = .625 = 62.5%

As with the inventory to net working capital ratio, a low percentage is a sign of strength and of creditworthiness. Too low a percentage may be a danger signal. If accounts payable are very small and inventories very large, it could indicate that the company's inventories are:

• Slow moving,
• Not in demand,
• Not marketable,
• Priced too high, or
• Inferior to competitors' product offerings.

Use these three ratios:

• Net sales to inventory,
• Inventory to net working capital, and
• Current debt to inventory.

They function as a single test to help you judge both the health of a company's inventories and how that health is affecting the company's overall financial condition. 

Edited by Michael C. Dennis, author of "Credit and Collection Handbook"