When reviewing accounts receivable turnover and inventory turnover,
(A) It is better for the turnover to be high than low.
(B) It is better for the turnover to be low than high.
(C) Turnover is not an important ratio.
(D) Inventory turnover should be equal to accounts receivable turnover,
The correct answer and explanation is:
The correct answer is (A) It is better for the turnover to be high than low.
Accounts receivable turnover and inventory turnover are key financial ratios used to measure how efficiently a company manages its assets. Both ratios are generally considered indicators of operational efficiency.
Accounts receivable turnover measures how often a company collects its accounts receivable during a given period. A high accounts receivable turnover ratio indicates that the company is collecting its outstanding debts quickly, which is beneficial as it enhances liquidity and reduces the risk of bad debts. A higher turnover means the company is able to convert its receivables into cash more efficiently, improving cash flow and potentially reducing the need for external financing.
Inventory turnover reflects how many times a company’s inventory is sold and replaced over a period. A high inventory turnover ratio suggests that the company is selling its inventory efficiently, minimizing holding costs such as storage, insurance, and obsolescence. It also implies that the business is in demand for its products, which is a positive sign of operational health.
Both ratios should be high because they indicate effective management. When turnover is high, it means the company is turning over its receivables and inventory quickly, enhancing liquidity and profitability. However, these ratios need to be balanced. An extremely high accounts receivable turnover might indicate overly strict credit policies, which could limit sales. Similarly, a very high inventory turnover could suggest stockouts or missed sales opportunities if inventory levels are too low.
In contrast, low turnover ratios signal inefficiencies. A low accounts receivable turnover could point to poor credit management or delayed collections, while low inventory turnover could indicate overstocking or slow-moving inventory. Therefore, high turnover is generally preferred.