The inventory turnover ratio is an important efficiency metric and compares the amount of product a company has on hand, called inventory, to the amount it sells. In other words, inventory turnover measures how many times inventory has sold during a period.
How to Calculate Inventory Turnover
The inventory turnover ratio can be calculated by dividing cost of goods sold by the average inventory for a particular period.
The reason average inventory is used is that most businesses experience fluctuating sales throughout the year, so the use of current inventory in the calculation can produce skewed results. For example, inventory for retailers like Macys Inc. (M) might rise during the months leading up to the holidays and fall during the months following the holidays.
Average inventory is typically used to calculate inventory turnover to account for seasonal variations in sales. The average inventory is calculated by adding the inventory at the beginning of the period to the inventory at the end of the period and dividing by two.
Formula for the Inventory Turnover Ratio
Inventory Turnover = Cost Of Goods Sold / ((Beginning Inventory + Ending Inventory) / 2)
The calculation of inventory turnover can also be done by dividing total sales by inventory. However, because sales are typically recorded at market value and inventory recorded at cost, this comparison can produce falsely inflated results.
Most companies use cost of goods sold (COGS) for the numerator instead of total sales because COGS reflects the total cost of producing goods for sale and excludes retail markup.
Interpreting Inventory Turnover
Companies use the inventory turnover ratio to help inform decisions about production, sales performance, and marketing.
The ratio provides management with insight into inventory purchasing and sales performance. If for example, inventory is high, it might be an indication that either sales are underperforming or too much inventory was purchased. Either sales need to increase, or the excess inventory may cost the company in storage fees.
It's important that sales and inventory purchases are in line with each other. If the two are not in sync, it will ultimately show up in the inventory turnover ratio.
Example Of inventory Turnover
A company has the following figures on their books:
The inventory turnover rate for this period is calculated by:
- $150,000 / (($75,000 + $12,000) / 2)
- Inventory turnover ratio = 3.45
This indicates that the company has sold its entire average inventory more than three times during the given period.
The optimal inventory turnover ratio depends on the business and the industry in question, so a company's current inventory ratio should always be compared to its past performance, as well as to the performance of other companies within its industry.
A low ratio could be an indication either of poor sales or overstocked inventory. Poor sales can be the result of ineffective advertising, poor quality, inflated price or product obsolescence. Excess inventory can also be costly since inventory sitting in a warehouse costs the business money to produce but generates no revenue.
While a high inventory turnover ratio is preferable to a low ratio, it's not always an indication of an efficient business model. A high ratio could reflect robust sales. However, a high ratio could also be because of low inventory levels, and if orders can't be filled on time to match sales, the company could lose customers.
Inventory turnover reflects a company's liquidity. For example, if inventory cannot be turned quickly, a company might run into cash flow problems. However, a company with a higher more efficient turnover rate would be able to generate cash very quickly.
Banks and creditors typically use inventory as collateral for loans. As a result, it's important for a company to demonstrate they have the sales to match their inventory purchases and that the process is managed properly.
Inventory turnover ratios vary by industry. For example, car companies like might have a lower ratio than clothing companies.
All the information necessary to calculate a business's inventory turnover is available on its financial statements. COGS can be found on the income statement, and both beginning and ending inventory can be found on the balance sheet.