Inventory turnover is an important metric for evaluating how efficiently a firm turns its inventory into sales. For a couple of key reasons, average inventory can be a better and more accurate measure when calculating the inventory turnover ratio.
Inventory turnover details how much inventory is sold over a period of time. One way to calculate it is as:
Cost of Goods Sold ÷ Average Inventory
Notice the need to calculate average inventory in the denominator. Average inventory is simply the average between the reported inventory level during the beginning of the measurement period and during the end of the measurement period.
Why Average Inventory?
When thinking about the differences between the income statement and balance sheet, one starts to understand why average inventory is used. Income statements cover a period of time, such as a quarter or single year. Using an annual 12-month period as an example, the stated cost of goods sold (COGS) figure will be recorded and accumulated throughout the year and then the average is determined from these numbers. In other words, average inventory is the COGS level that builds from January through December for a firm that uses a calendar year as its fiscal full year period.
In contrast, a balance sheet represents the state of a firm’s assets and liabilities at a certain point in time. For the calendar year example above, this same firm’s annual inventory level will be the snapshot on December 31. For this reason, it is certainly arguable that taking the average of the inventory level at the beginning and ending of the year is more accurate.
The need for average inventory is even more justifiable for a firm that experiences seasonality. For many retailers, inventory levels build during the end of the year to prepare for sales during the all-important holiday season that starts with Black Friday (to indicate that a retailer operates in the red all year, until it starts earning profits and operates in the black)
Assuming a quarterly inventory turnover estimate for retailer Target Corp (TGT), its fiscal 2013 inventory level stood at $8.4 billion in July but jumped nearly 30% to $10.4 billion in October, just as it was preparing for the holiday season. Using average inventory helps smooth these two disparate periods.
The Bottom Line
Managing inventory levels is important for most businesses and this is especially true for retailers and any company that sells physical goods. Average inventory is needed for a more accurate picture in a couple of key cases.
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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