A:

Managing inventory levels is important for most businesses and this is especially true for retailers and any company that sells physical goods. The inventory turnover ratio is a key measure for evaluating just how efficient management is at managing company inventory and generating sales from it.

Inventory Turnover

Like a typical turnover ratio, inventory turnover details how much inventory is sold over a period of time. It is calculated as:

Cost of Goods Sold ÷ Average Inventory

Or

Sales ÷ Inventory

Usually, a higher inventory turnover ratio is preferred, as it indicates that more sales are being generated given a certain amount of inventory. Alternatively, for a given amount of sales, using less inventory to do so will improve the ratio.

For more, check out "What does a high inventory turnover tell investors about a company?"

Sometimes a very high inventory ratio could result in lost sales, as there is not enough inventory to meet demand. It is always important to compare the inventory turnover ratio to the industry benchmark to asses if a company is successfully managing its inventory.

Days Sales of Inventory (DSI) or Days Inventory

The inventory turnover ratio on its own takes some time to put into perspective. Going a step further, days sales of inventory, also known as days inventory, is simply the inverse of the inventory turnover ratio multiplied by 365. This puts the figure into a daily context, as follows:

(Average Inventory ÷ Cost of Goods Sold) x 365

DSI significantly changes between industries and it is important to compare it against peer companies. Businesses that sell perishable products like supermarkets or groceries stores have lower inventory days than business that sell furniture or appliances.

Example

For the fiscal year ended Jan. 2014, Wal-Mart Stores Inc (WMT) reported annual sales of $476.3 billion, year-end inventory of $44.9 billion, and annual cost of goods sold (or cost of sales) of $358.1 billion.

Its inventory turnover for the year equals:

$358.1 billion ÷ $44.9 billion = 8.0

Its days inventory equals:

(1 ÷ 8) x 365 = 46 days.

This indicates that Wal-Mart sells its entire inventory within a 46-day period, which is quite impressive for such a large, global retailer.

The Bottom Line

The inventory turnover ratio is one of the best indicators of how efficiently a company is turning its inventory into sales. Even better, the days inventory ratio puts it into a daily context.

At the time of writing, Ryan C. Fuhrmann did not own shares in any of the companies mentioned in this article.

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