Importance of the Gross Margin and Inventory Turnover Ratios

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Today’s short accounting course is about financial ratios and the importance of proper analysis. There are many different types of financial ratios in personal and corporate finance, but few are used as much as the gross margin ratio and the inventory turnover ratio.

The gross margin ratio is calculated by dividing the gross margin by the net sales. Both of these numbers are usually calculated on an annual basis and can be found on the income statement.

The gross margin or gross margin ratio calculates the percentage of net sales that can be used to cover the operating expenses of the company. In other words, this ratio shows the profitability of a company’s inventory and cost habits.

Generally, higher margins are always preferred to lower margins because this means the company is more profitable.

Selling inventory at a higher margin can usually result in higher inventory turns. The inventory turnover ratio, calculated by dividing the cost of goods sold by the annual average inventory, measures the amount of times the total inventory was bought and sold for the year.

Since companies want to convert their inventory into cash sooner, they want a higher inventory ratio. This would imply that the inventory turns or completely sells during the year more times. Most retailers have an average inventory ratio of four. These companies sell their entire inventory each quarter or the equivalent there of. This makes sense since most apparel retailers have seasonal fashion that must be sold before the end of the season.

Both of these ratios are important for many professionals, bankers, and creditors to analyze how well businesses are doing and whether they are valuable enough to do business with. There are many other financial ratios that we will discuss in other courses. Feel free to browse our library and suggest something if you don’t see what you are looking for.

References:

My Accounting Course : Gross Margin Ratio
My Accounting Course : Inventory Turnover Ratio