What is a limitation of the inventory turnover ratio?
One limitation of the inventory turnover ratio is that it tells you the average number of times per year that a company's inventory has been sold. For example, if during the past year a company had sales of $7 million, cost of goods sold of $5 million, and its inventory cost averaged $1 million, the company's inventory turnover was on average 5 ($5 million of cost of goods sold divided by $1 million of inventory cost). A turnover ratio of 5 indicates that on average the inventory had turned over every 72 or 73 days (360 or 365 days per year divided by the turnover of 5).
However, the average turnover ratio of 5 might be hiding some important details. What if four items make up 40% of the company's sales and account for only 10% of the inventory cost? These fast selling items will have a turnover ratio of 20 (cost of goods sold of $2,000,000 divided by their average inventory cost of $100,000) meaning these items turn every 18 days (360 days divided by the turnover of 20). This means that the remaining items in inventory will have a cost of goods sold of $3,000,000 and their average inventory cost will be $900,000. As a result, the majority of the items in inventory will have an average turnover ratio of 3.3 ($3,000,000 divided by $900,000). In other words, the majority of items are turning on average every 109 days (360 days divided by the turnover ratio of 3.3). That's a significant difference from the 72 days that we first computed on the totals.
People within the company can overcome the shortcomings described above, since they have access to all of the sales and inventory detail. A computer generated report can compute the inventory turnover ratio and the days' sales in inventory for each and every item sold and/or held in inventory. By reviewing each item, the slow moving items will not be hidden behind an average.
