What Is Inventory Turnover?
Inventory turnover is the rate at which a company replaces inventory in a given period due to sales. Calculating inventory turnover helps businesses make better pricing, manufacturing, marketing, and purchasing decisions. Well-managed inventory levels show that a company's sales are at the desired level, and costs are controlled. The inventory turnover ratio is a measure of how well a company generates sales from its inventory.
- Inventory includes all the goods a company has in its stock that will ultimately be sold.
- Inventory turnover indicates the rate at which a company sells and replaces its stock of goods during a particular period.
- The inventory turnover ratio formula is the cost of goods sold divided by the average inventory for the same period.
Reading The Inventory Turnover
Understanding Inventory Turnover
Inventory is the account of all the goods a company has in its stock, including raw materials, work-in-progress materials, and finished goods that will ultimately be sold. Inventory typically includes finished goods, such as clothing in a department store.
However, inventory can also include raw materials that go into the production of finished goods. For example, the fabric used to make clothing would be inventory for a clothing manufacturer.
Inventory turnover is the number of times a company sells and replaces its stock of goods in a period. As such, inventory turnover provides reflects how well a company manages costs associated with its sales efforts.
- The higher the inventory turnover, the better, since high inventory turnover typically means a company is selling goods quickly, and there is considerable demand for their products.
- Low inventory turnover, on the other hand, would likely indicate weaker sales and declining demand for a company’s products.
- Inventory turnover indicates how well a company is managing its stock. A company may overestimate demand for their products and purchase too many goods. This would manifest as low turnover. Conversely, if inventory turnover is high, this indicates that there is insufficient inventory and the company misses out on sales opportunities.
- Inventory turnover also shows whether a company’s sales and purchasing departments are in sync. Ideally, inventory should match sales. It can be costly for companies to hold onto inventory that isn’t selling. Thus, inventory turnover indicates sales effectiveness and the management of operating costs. Alternatively, for a given amount of sales, using less inventory improves inventory turnover.
Calculating Inventory Turnover
As with a typical turnover ratio, inventory turnover details how much inventory is sold over a period. To calculate the inventory turnover ratio, cost of goods (COGS) is divided by the average inventory for the same period.
- Cost of goods sold ÷ average inventory or sales ÷ inventory
Average inventory is used in the ratio because companies might have higher or lower inventory levels at certain times of the year. For example, retailers like Best Buy Co. Inc. (BBY) would likely have higher inventory leading up to the holidays in Q4 and lower inventory levels in Q1 following the holidays.
COGS is a measure of a company's production costs of goods and services. COGS can include the cost of materials, labor costs directly related to goods produced, and any factory overhead or fixed costs that are directly used in the production of goods.
Days Sales of Inventory (DSI) or Days Inventory
Days sales of inventory (DSI) measures how many days it takes for inventory to turn into sales. DSI, also known as days inventory, is calculated by taking 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
A lower DSI is ideal since it would translate to fewer days needed to turn inventory into cash. However, DSI values can vary between industries. As a result, it's important to compare the DSI of a company with its peers. For example, companies that sell groceries, like Kroger supermarkets (KR), have lower inventory days than companies that sell automobiles such as General Motors Co. (GM).
Example of an Inventory Turnover Calculation
Walmart's inventory turnover for the year equaled:
- $385.3 billion ÷ $44.3 billion = 8.7
Its days inventory equal:
- (1 ÷ 8.7) x 365 = 42 days
This indicates that Walmart sells its entire inventory within a 42-day period, which is impressive for such a large, global retailer.
The inventory turnover ratio is an effective measure of how well a company is turning its inventory into sales. The ratio also shows how well management is managing the costs associated with inventory and whether they're buying too much inventory or too little.
Additionally, inventory turnover shows how well the company sells its goods. If sales are down or the economy is under-performing, it may manifest as a lower inventory turnover ratio. Usually, a higher inventory turnover ratio is preferable because it indicates that more sales are generated from a certain amount of inventory.
Sometimes a high inventory ratio could result in lost sales, as there is insufficient inventory to meet demand. The inventory turnover ratio should be compared to the industry benchmark to assess if a company is successfully managing its inventory.