The liquidity ratios discussed so far (elate to the liquidity of a firm as a whole. Another way of examining the liquidity is to determine how quickly certain current assets are converted into cash. The ratios to measure these are referred to as turnover ratios. These are as activity ratios, covered in detail later in this chapter. In fact, liquidity ratios are not independent of activity ratios. Poor debtor or inventory turnover ratios limit the usefulness of the current. Both obsolete/unsalable inventory and uncollected debtors are unlikely to he sources of cash, Therefore, the liquidity ratios should be examined in conjunction with relevant turnover ratios affecting liquidity. The three relevant turnover ratios are (i) inventory turnover ratio; (ii) debtors turnover ratio: and (iii) creditors turnover ratio.
Inventory Turnover Ratio
It is computed by dividing the cost of goods sold by the average inventory. Thus,
The cost of goods sold means sales minus gross profit. The average inventory refers to the simple average of the opening and dosing inventory. The ratio indicates how fast inventory is sold: A high ratio is good from the viewpoint of liquidity and rice vice versa. A low ratio would signify that inventory does not sell fast and stays on the shelf or in the warehouse (or a long time.