Notes on Inventory Turnover, GPM & NPM (Cambridge Chapter 12)

Inventory Turnover and Related Indicators

Key purpose: assess trading performance using liquidity, profitability and stability indicators; focus on Inventory Turnover (ITO) and strategies to manage Inventory.

ITO is an efficiency indicator that measures how quickly inventory is converted into sales.
Two common forms:
- ITO (times) = Cost of Goods Sold / Average Inventory
- ITO (days) = (Average Inventory / Cost of Goods Sold) × 365
Average Inventory = (Opening Inventory + Closing Inventory) / 2
Example (illustrative):
- Opening Inventory = 55,000; Closing Inventory = 45,000; COGS = 300,000
- ext{Average Inventory} = \frac{55000 + 45000}{2} = 50000
- ext{ITO (days)} = \frac{50000}{300000} \times 365 \approx 60.8 \text{ days}
Interpretation:
- Lower days = faster turnover = better liquidity; higher days = slower turnover = liquidity risk.
- Very fast turnover could indicate understocking or low pricing; very slow turnover suggests excess inventory and potential cash flow issues.
What affects ITO:
- Changes in Cost of Goods Sold (COGS)
- Changes in Average Inventory (inventory on hand)
- Revenue shifts and seasonal effects
Benchmarks for ITO evaluation:
- Previous reporting period
- Budgeted targets
- Industry averages

When ITO is too slow (high days):
- Increase sales (improve inventory mix, marketing, promotions, discounts on slow lines)
- Reduce on-hand inventory (smaller, more frequent orders; Just-In-Time ordering)
When ITO is too fast (very low days):
- Ensure inventory levels are sufficient to meet demand; avoid sacrificing supplier discounts or increasing stockouts
Balancing act: maintain enough stock to meet demand without incurring high carrying costs or obsolescence
Practical strategies:
- Maintain an appropriate inventory mix and expand fast-selling lines
- Promote complementary goods to boost overall turnover
- Keep inventory up to date (address obsolescence/tech changes)
- Rotate inventory to move older stock first
- Set minimum and maximum inventory levels; use Just-In-Time where feasible
- Appoint an Inventory Manager for accuracy and controls
- Market strategically and ethically; monitor selling prices vs. costs
- Monitor seasonal demand and security to prevent losses

Internal control: procedures to protect assets from theft/damage/misuse; include controls to prevent fraud and theft.
Non-financial indicators used with ITO:
- Customer satisfaction, returns, complaints, and sales enquiries
- Employee satisfaction, turnover, absenteeism, and performance appraisals
- Economic and market factors: unemployment rate, number of competitors, interest rates, inflation

Purpose: measure the percentage of net sales revenue retained as gross profit (before other expenses), reflecting markup on goods sold.
Formula:
- \text{GPM} = \frac{\text{Net Sales} - \text{COGS}}{\text{Net Sales}} \times 100\%
Interpretation:
- Higher GPM means a larger portion of sales revenue remains after covering COGS; indicates a larger markup.
- Note: GPM does not account for other operating expenses.
Example: Net Sales = 54,400; Gross Profit = 22,400
- \text{GPM} = \frac{22,400}{54,400} \approx 0.4118 = 41.18\%
Relationship to NPM:
- GPM typically higher than NPM, since NPM subtracts all expenses.
How to improve GPM (high level):
- Increase selling price carefully to avoid demand drop
- Reduce COGS (negotiate with suppliers, bulk purchasing where feasible)
Cautions: a higher GPM doesn’t guarantee higher net profit; volume and other costs matter.

Purpose: measure the percentage of net sales that remains after all expenses have been paid.
Formula:
- \n\text{NPM} = \frac{\text{Net Profit}}{\text{Net Sales}} \times 100\%
Interpretation:
- A higher NPM indicates stronger expense control and profitability per sales dollar.
- Requires benchmarking to assess adequacy (previous period, budget, industry).
Example: Net Sales = 54,400; Net Profit = 13,200
- \text{NPM} = \frac{13,200}{54,400} \approx 0.2426 = 24.26\%
Benchmarks and interpretation:
- Compare with prior period (improvement suggests better control) or industry averages (e.g., industry average 30%).
Factors influencing changes:
- Increase in revenue or decrease in expenses raises NPM
- Decrease in revenue or increase in expenses lowers NPM
Strategies to improve NPM (high level):
- Control expenses; optimize wages and overheads
- Improve efficiency; manage advertising and marketing spend
- Consider financing costs and other operational levers

Why cash purchases of inventory do not appear on the income statement: purchases feed into COGS via the cost flow until sold; cash payments affect cash flow, not directly profit until related revenue/COGS are recognized.
Benchmarks for GPM and NPM:
- Compare to previous periods, budgets, and industry averages to judge performance.
- Industry benchmarks help assess whether margins are competitive.

Average Inventory:
ext{Average Inventory} = \frac{I{0} + I{1}}{2}
Inventory Turnover (days):
ext{Inventory Turnover (days)} = \frac{\text{Average Inventory}}{\text{COGS}} \times 365
Inventory Turnover (times):
ext{Inventory Turnover (times)} = \frac{\text{COGS}}{\text{Average Inventory}}
Gross Profit Margin:
\text{GPM} = \frac{\text{Net Sales} - \text{COGS}}{\text{Net Sales}} \times 100\%
Net Profit Margin:
\text{NPM} = \frac{\text{Net Profit}}{\text{Net Sales}} \times 100\%

If ITO is 60 days this year vs 45 days last year, what does that imply about liquidity and inventory management?
If GPM improves but NPM falls, what might be happening to other expenses?
What non-financial indicators would you monitor to support decisions about inventory turnover and stocking levels?