Inventory turnover measures the rate at which a company purchases and resells its products (or inventory) to its customers. 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, or headed for, trouble.

Key Takeaways

  • Inventory turnover is the speed with 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 low and high are only relative to the company's particular sector or industry. No specific number exists 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, the 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=SalesInventory\begin{aligned} &\text{Inventory Turnover} = \frac{ \text{Sales} }{ \text{Inventory} } \\ \end{aligned}Inventory Turnover=InventorySales

Inventory Turnover=COGSAverage Value of Inventorywhere:COGS=Cost of goods sold\begin{aligned} &\text{Inventory Turnover} = \frac{ \text{COGS} }{ \text{Average Value of Inventory} } \\ &\textbf{where:} \\ &\text{COGS} = \text{Cost of goods sold} \\ \end{aligned}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 Example

In sectors such as the grocery store industry, it is normal to have very high inventory turnover. According to CSIMarket, an independent financial research firm, the grocery store industry had an average inventory turnover of 13.56 (using the cost of goods method) for 2018, which means the average grocery store replenishes its entire inventory over 13 times per year.

This high inventory turnover is largely due to the fact that grocery stores 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.

In addition to high volume/low margin industries needing a higher inventory turnover to remain cash-flow positive, a high inventory turnover can also signal an industry as a whole is enjoying 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 goods that can become obsolete or outdated.