The term sales to inventory ratio refers to a calculation that allows a management team to understand the level of inventory needed on hand to support sales. The metric takes the company's annual cost of goods sold and divides it by yearend inventory.
Sales to Inventory Ratio = Cost of Goods Sold / Inventory
Liquidity measures allow the investor-analyst to understand the company's long term viability in terms of fiscal health. This is usually assessed by examining balance sheet items such as accounts receivable, use of inventory, accounts payable, and short-term liabilities. One of the ways to understand how much cash a company needs to support a given level of sales is by calculating its sales to inventory ratio.
Calculating the sales to inventory ratio allows a company's finance team to understand how much cash will be tied up in inventory to support sales of their products. The calculation uses historical cost of goods sold and divides it by the ending inventory for the same annualized timeframe. The result of the calculation is the number of times inventory turns over each year. The value is useful not only as a benchmark, but also to determine the level of inventory needed when a change in overall sales is forecast.
Company ABC ran a successful promotional program that forecasters believe will result in a permanent increase to sales. The CFO would like to understand how much additional cash will be allocated to inventory going forward. She also wanted to make sure the company wasn't holding excess inventory. She asked her analytical team to compare the last two year's sales to inventory ratios. The finance team put the following table together.
|Prior Year||Current Year|
|Cost of Goods Sold||$123,840,000||$148,608,000|
|Sales to Inventory Ratio||6.5||5.2|
The analysis revealed the company was holding excess inventory. If last year's inventory was at the historical 6.5 level, Ending Inventory should have been $5,678,000 lower than its current level. Based on this information, the CFO set up a meeting with the COO to discuss her perceived over-inventory finding.