The types and volumes of products a business owner maintains in his inventory can spell the difference between business success and failure. Net-sales-to-inventory ratio is one of several accounting tools that you can use to effectively manage inventory. Making critical inventory management decisions without such tools can jeopardize the operational efficiency of your business.
Financial analysts and accountants sometimes use this ratio to determine the number of times inventory in stock has moved or "turned over" during the given year. It gives you an idea of how well your inventory is producing sales and allows you to establish the relationship that exists between average inventory and net sales. The ratio is often compared to other ratios to measure efficiency of inventory management.
Computing the net-sales-to-inventory ratio is a two-step process. First, add all inventories at the end of each month of the given year and divide the total by 12 to get the average inventory. Note that inventory must be valued at cost to measure the value of the capital invested in inventory. Next, divide total net sales for the year by the average inventory to get the net-sales-to-inventory ratio.
Assume that ABC Company's total inventory for the year is $120,000 and that its total net sales for the same period are $96,000. Dividing $120,000 by 12 will result to an average inventory of $10,000. Dividing $96,000 net sales for the year by the average inventory of $10,000 will result to a net-sales-to-inventory ratio of 9.6.
Theoretically, the 9.6 ratio of ABC Company mentioned in the preceding example would mean that the $10,000 average monthly inventory generated sales equivalent to 9.6 times its value. This ratio clearly establishes the financial relationship that exists between average inventory and net sales. The higher the ratio, the better the efficiency. Comparing this ratio against the company's own historical records allows managers and owners to see trend changes. Comparing it against competitors and peer businesses allows them to know if they are managing their inventory better or worse than others.