ABREMA: glossary: inventory turnover

Inventory turnover

Cost of sales/Average inventory

This is one of the many ratios used by auditors in ratio analysis. As with all ratio analysis, the auditor compares the actual value of the ratio at a point of time with the expected value of the ratio and investigates any unexpected change. To avoid the actual value of the ratio biasing the auditor's estimation of the expected value, auditors estimate the expected value before calculating the actual value. Average inventory in the ratio (the average value of opening and closing inventory) normally includes the value of work in progress.

Inventory turnover provides the auditor with an estimate of the number of times inventory "turns over" (i.e. is replaced), on average, during a period. A high value indicates to the auditor that inventory is turning over quickly, a low value that it is turning over slowly. By itself, the ratio does not convey a lot of meaning. However, ratio anlaysis involves a comparison of the ratio, whhcih provides more meaningful information. For example:

Comparison of the ratio with an industry average (ensuring the method of calculating the industry ratio is the same method used to calculate the client's ratio). This provides the auditor with an indication of whether the client is performing better or worse than the industry as a whole. The comparison is useful when obtaining a preliminary knowledge of the client's business.
Comparison of the ratio between different product lines. This comparison provides the auditor with an indication of which product lines may require further investigation. The comparison is useful when obtaining a detailed knowledge of the client's business.
Comparison of the ratio this year with last year. An increase in the ratio over the previous year may be an indication to the auditor that inventories are running down; a decrease may indicate that inventories are building up, perhaps as a result of obsolete inventory not being written off, or even the presence of fictitious inventory (see Journal of Accountancy article Ghost Goods: How to Spot Phantom Inventory). The use of the ratio in this manner is a very common substantive audit procedure. In many established businesses, this ratio remains relatively unchanged from year to year, so even a small change (e.g. from 4.0 times to 3.9 times) may require investigation.

Note that some auditors, when using this ratio as a substantive procedure, use closing inventory as the denominator rather than the average of opening and closing inventory. When average inventory is used, and closing inventory is misstated, the effect of the misstatement on the ratio is halved and a change in the ratio over the previous year may not appear unusual. However, when an auditor uses closing inventory as the denominator rather than average inventory, and inventory is misstated, the auditor is more likely to observe the misstatement because the amount of the misstatement, and its effect on the ratio, is not halved.

Other ratios used by auditors include:

Activity Based Risk Evaluation Model of Auditing

Inventory turnover