This implies that it would take two years to sell his entire inventory and indicates that the company does not have very good inventory control. So, Brandon’s inventory turnover is 0.5, which means that he only sold half of his inventory during the year. $$Inventory\: Turnover\: Ratio = \dfrac = 0.50$$ So what is business inventory? Inventory or stock of a business takes into account the finished goods ready for resale, the raw materials used in the production of the finished goods, and the goods that are still a work in progress.įor example, a bread manufacturing company inventory will be the final bread ready for sale, raw material used to produce the bread, and the bread still in the manufacturing process. Put simply, the ratio measures the number of times a company sold its total average inventory dollar amount during the year. This year Trisha may have made less sales, but she cut expenses and was able to convert more of these sales into profits with a ratio of 25 percent.Inventory turnover is an efficiency ratio that shows how many times a company sells and replaces inventory in a given time period. Contrast that with this year’s numbers of $800,000 of net sales and $200,000 of net income. Last year Trisha’s net sales were $1,000,000 and her net income was $100,000.Īs you can see, Trisha only converted 10 percent of her sales into profits. Last year Trisha had the best year in sales she has ever had since she opened the business 10 years ago. Trisha’s Tackle Shop is an outdoor fishing store that selling lures and other fishing gear to the public. This ratio is also effective for measuring past performance of a company. Like most profitability ratios, this ratio is best used to compare like sized companies in the same industry. Since most of the time generating additional revenues is much more difficult than cutting expenses, managers generally tend to reduce spending budgets to improve their profit ratio. They can do this by either generating more revenues why keeping expenses constant or keep revenues constant and lower expenses. That is why companies strive to achieve higher ratios. This ratio also indirectly measures how well a company manages its expenses relative to its net sales. In other words, it measures how much profits are produced at a certain level of sales. The profit margin ratio directly measures what percentage of sales is made up of net income. Net income equals total revenues minus total expenses and is usually the last number reported on the income statement. Net sales is calculated by subtracting any returns or refunds from gross sales. The profit margin ratio formula can be calculated by dividing net income by net sales. The return on sales ratio is often used by internal management to set performance goals for the future. An extremely low profit margin formula would indicate the expenses are too high and the management needs to budget and cut expenses. In other words, outside users want to know that the company is running efficiently. Investors want to make sure profits are high enough to distribute dividends while creditors want to make sure the company has enough profits to pay back its loans. In other words, the profit margin ratio shows what percentage of sales are left over after all expenses are paid by the business.Ĭreditors and investors use this ratio to measure how effectively a company can convert sales into net income. The profit margin ratio, also called the return on sales ratio or gross profit ratio, is a profitability ratio that measures the amount of net income earned with each dollar of sales generated by comparing the net income and net sales of a company.
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