Inventory Turnover Ratio What It Is, How It Works and how to calculate

Marketopedia / Fundamental Analysis / Inventory Turnover Ratio What It Is, How It Works and how to calculate

The Inventory turnover ratio reflects how often a company replenishes their inventory, and the Inventory number of Days shows the amount of time it takes to convert inventory into cash. A low number indicates that the company’s products are selling quickly. Here’s how it’s calculated:

365 divided by Inventory turnover = Inventory no. of days

The inventory number is usually determined over a year. Thus, the 365 represented in the equation refers to the number of days in a calendar year.

Calculating this for ARBL:

= 365 / 7.8

= 46.79 days

~ 47.0 days

It can be concluded that ARBL’s inventory turnover is about 47 days. To make a comparison with their competitors, it is essential to know how quickly the company’s products are selling.

What do you make of this scenario? Can you come to any conclusions?

1. This company under consideration has an impressive inventory turnover rate.
2. Due to a high inventory turnover rate, the number of days for stock is minimal.

At first glance, the company appears to have great inventory management. A high inventory turnover ratio implies that they are replenishing stock promptly, while a low inventory number of days suggests they can quickly turn goods into cash. Both are excellent indicators of effective management.

Nonetheless, even in the event of a product that is highly sought-after yet has low production capacity, the inventory turnover will still be high and stock days low. This nevertheless raises doubts about the firm’s ability to make more of the same product.

1. What is preventing the company from increasing its output?
2. Can they not boost output due to a lack of money?
3. If they need money, why don’t they look into obtaining a loan from the bank?
4. Have they sought financial assistance from a bank, but have been unsuccessful in obtaining a loan?
5. What is preventing them from gaining a loan?
6. What if the management lacks a strong track record? It may result in banks being reluctant to provide a loan.
7. When resources aren’t an issue, why can’t the company increase its output?
8. Is it challenging to source raw materials? Are there any governmental regulations for the raw material needed (e.g. Coal, power, Oil)?
9. Obtaining the required raw materials can pose a challenge. Does this impede scalability?

If any of the points above are true, it could raise a red flag and investing in the company may not be ideal. Therefore, to gain an understanding of any production issues, one should thoroughly read the entire annual report, with particular attention to the management discussion & analysis report.

Be sure to look into the production details whenever you find remarkable inventory figures.

Accounts Receivable Turnover Ratio

Understanding the receivable turnover ratio should be quite straightforward, once you understand the inventory turnover ratio. This ratio indicates how many times in a given period the company receives cash from its debtors and customers; a higher number indicates that cash is collected more frequently.

The calculation for this is:

Revenue divided by Average Receivables = Accounts Receivable Turnover Ratio

From the balance sheet we know,

Trade Receivable for the FY13 : Rs.380.67 Crs

Trade Receivable for the FY14 : Rs. 452.78 Crs

Average Receivable for the FY13 : Rs.416.72

For FY14, Operating Revenue= Rs.3437 Crs

Hence the Receivable Turnover Ratio is:

= 3437 / 416.72

= 8.24 times a year

~ 8.0 times

ARBL clients submit payments to the firm roughly 8.24 times annually, or approximately once every six weeks.

The Days Sales Outstanding (DSO), represents the average number of days it takes for a company to collect payment from its customers.

The days sales outstanding ratio reflects the average amount of time it takes to receive payments from customers. This number is a measure of the efficiency of a company’s collection department, as prompt collections allow funds to be used more quickly for other activities. The formula can be calculated using:

365 divided by Receivable Turnover Ratio = Days Sales outstanding

Solving this for ARBL,

= 365 / 8.24

= 44.29 days

It typically takes ARBL around 45 days to go from issuing an invoice to receiving payment.

Receivables Turnover and DSO both demonstrate the credit policy of a firm. In order to be run efficiently, one should ensure a suitable equilibrium between the credit policy and the credit advanced to their customers.

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