How is the inventory turnover ratio computed?

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The inventory turnover ratio is a key financial metric that measures how efficiently a business manages its inventory. It indicates how many times inventory is sold and replaced over a specific period, typically a year. The correct method for computing this ratio is to take the cost of goods sold and divide it by the average inventory.

Using cost of goods sold as the numerator allows the calculation to reflect the actual cost of the goods that were sold during the period, providing a direct measure of how efficiently inventory is being utilized in generating sales. Dividing this figure by average inventory, which represents the average level of inventory maintained over the same period, normalizes the ratio to account for fluctuations in inventory levels that can occur due to seasonal variations in a business's operations.

This computation provides valuable insights to business owners and managers regarding inventory management and can help in making informed decisions related to purchasing, production, and sales strategies. High turnover ratios may suggest strong sales or effective inventory management, while low ratios might indicate overstocking or issues with product demand.

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