Inventory turnover measures the rate at which a company purchases and resells its products (or inventory) to its customers. In some industries, low inventory turnover can indicate bad management, poor purchasing practices or selling techniques, faulty decision-making, or the buildup of inferior or obsolete goods. As a result, investors usually don't like to see a low inventory turnover ratio in a company; it can suggest the business is in trouble or headed for trouble.
- Inventory turnover is the speed at which a company purchases and resells its inventory.
- Slow inventory turnover could be a sign of poor management or inefficient purchasing practices.
- High volume, low margin industries—such as retailers—tend to have the highest inventory turnover.
- High inventory turnover can signal an industry as a whole is seeing strong sales or has efficient operations.
It is important to realize that high or low inventory figures are only meaningful in relation to the company's sector or industry. There is no specific number to signify what constitutes a good or bad inventory turnover ratio across the board; desirable ratios vary from sector to sector (and even sub-sectors).
Investors should always compare a particular company's inventory turnover to that of its sector, and even its sub-sector, before determining whether it's low or high. For example, some industries that tend to have the most inventory turnover are those with high volume and low margins, such as retail, grocery, and clothing stores.
Calculating Inventory Turnover
There are a couple of ways to calculate inventory turnover:
Inventory Turnover=Average Value of InventoryCOGSwhere:COGS=Cost of goods sold
Using the first method: If a company has an annual inventory amount of $100,000 worth of goods and yearly sales of $1 million, its annual inventory turnover is 10. This means that over the course of the year, the company effectively replenished its inventory 10 times. Most companies consider a turnover ratio between six and 12 to be desirable.
Using the second method: If a company has an annual average inventory value of $100,000 and the cost of goods sold by that company was $850,000, its annual inventory turnover is 8.5. Many analysts consider the costs of goods method to be more accurate because it reflects what items in inventory actually cost a company.
Inventory Turnover by Industry
CSIMarket, an independent financial research firm, compiles statistics on sector-by-sector economic metrics, based on the median figures for companies in that sector. The boundaries of these sectors are somewhat arbitrary, and different analysts might divide the economy into different sectors.
By this analysis, the financial sector has the highest inventory turnover, using the COGS method outlined above. This is likely due to the intangible nature of financial products, combined with the high-speed trading algorithms that are now common in many financial markets. The financial sector has a median inventory turnover ratio of 48.76, meaning that these companies can replenish their ordinary inventory 48 times in a single year.
Among tangible goods, the "retail" and "consumer discretionary" sectors have the highest turnover ratios. Retail industries have a turnover ratio of 10.86, meaning that they replenish their entire inventory more than ten times in one year. Consumer discretionary refers to goods that are nonessential but desirable to those with a sufficient income, such as high-end fashion and entertainment. Businesses in the consumer discretionary sector replenish their inventory nearly seven times per year.
This high inventory turnover is largely due to the fact that retail and consumer goods sellers need to offset lower per-unit profits with higher unit sales volume. These types of low-margin industries have proportionately higher sales than inventory costs for the year.
While turnover sometimes indicates an industry with low per-unit profits, a high inventory turnover can also signal a company with strong sales or has very efficient operations. It is also a signal to investors that the sector is a less risky prospect since companies within it replenish cash quickly and don't get stuck with unsold goods.
CSI Market. "Inventory Turnover Ratio Ranking by Sector."