How to Use the Inventory Turnover RatioThe Inventory Turnover Ratio is used to determine whether or not a business is maintaining adequate levels of inventory.
This ratio represents the number of times the inventory "turned over" during the period we are measuring. Inventory Turnover is generally higher in the retail industry. The inventory of equipment and machinery will turn over much less frequently, but will have a higher profit margin per product. Grocery stores and retailers of perishable goods have the highest ratios, where profit margins are lower but sales are made in larger volumes. The ratio should be compared with competitors and the industry average. Let's see how Sunny Sunglasses compares with its industry and competition: Beginning Inventory = $0 (Beginning Inventory equals the Ending Inventory of the prior period, and Ending Inventory as of December 31, 2006 was $0 since Sunny Sunglasses was not in business yet). Ending Inventory = $5,625 as of December 31, 2007. Average Inventory
The Cost of Goods sold on the 2007 Income Statement is $43,200. Inventory Turnover Ratio
This means that Sunny Sunglasses Shop is turning over inventory 15.36 times per year. The next step is to add meaning to this number by comparing it with the industry average:
The ratio estimated for Sunny Sunglasses is about four times greater than the Inventory Turnover of its closest and largest competitor, Sunglasses Hut Int. (Luxottica Group) at 3.7. This indicates that Sunny's main competitor, Luxottica, may have products that are too expensive, or management may not have correctly estimated demand. It also means that Sunny Sunglasses is more in line with higher industry averages than its closest competitor. The company has more accurately forecasted demand while keeping inventory at an acceptable level with sales. The retail sector generally has a higher Inventory Turnover than other industries, as products are less expensive and turnover more quickly. Holding inventories too long in the retail industry risks inventory write-downs, since seasonality and new product lines could quickly create lower demand and slower sales for older inventories. Another calculation, based on the Inventory Ratio, is to determine how many days it took to clear the inventory. To calculate the number of days, simply divide 365 by the Inventory Turnover Ratio. Luxottica Group Average Days to Clear Inventory
Sunny Average Days to Clear Inventory
Industry Average Days to Clear Inventory
Sunny Sunglasses Shop cleared its inventory every 24 days, while the Specialty Retail Industry averages every 20 days. Luxottica Group is holding inventory for 99 days, five times longer than the industry average. Sunny Sunglasses Shop has maintained a slightly lower but acceptable ratio when compared with the industry. Its main competitor has, on the other hand, held inventory significantly longer than industry averages, which creates the risk of writing off or discounting inventory. Luxottica may have product lines or styles that are not currently in demand, or product pricing may not be competitive. When inventory turnover is low, a company must reassess market demand, products offered to meet specific demand, as well as product pricing. Recently Luxottica Group reevaluated styles offered, and discovered that products were too homogeneous in nature and did not meet the demand for more assortment options. Luxottica Group recently purchased Oakley, an icon brand of sunglasses with optical and technological superiority over many competitors, and a bellwether in the sports sector. This will allow Luxottica to use its international distribution channels to gain a stronger foothold in sport eyeware with an innovative and exclusive product line, which may increase Inventory Turnover significantly.
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