Managing inventory levels is important for companies since it can show whether sales efforts are effective or whether costs are being controlled. The inventory turnover ratio is an important measure of how well a company generates sales from its inventory.
What Is Inventory?
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, called work-in-progress. For example, the cloth used to make the clothing would be inventory for the clothing manufacturer.
Reading The Inventory Turnover
What Is Inventory Turnover and How Is It Interpreted?
Inventory turnover is the number of times a company sells and replaces its stock of goods during a period. Inventory turnover provides insight as to how the company manages costs and how effective their sales efforts have been.
- The higher the inventory turnover, the better since a high inventory turnover typically means a company is selling goods very quickly and that demand for their product exists.
- Low inventory turnover, on the other hand, would likely indicate weaker sales and declining demand for a company’s products.
- Inventory turnover provides insight as to whether a company is managing its stock properly. The company may have overestimated demand for their products and purchased too many goods as shown by low turnover. Conversely, if inventory turnover is very high, they might not be buying enough inventory and may be missing 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 quite costly for companies to hold onto inventory that isn’t selling. This is why inventory turnover can be an important indicator of sales effectiveness but also for managing operating costs. Alternatively, for a given amount of sales, using less inventory to do so will improve inventory turnover.
Calculating Inventory Turnover
Like a typical turnover ratio, inventory turnover details how much inventory is sold over a period of time. To calculate the inventory turnover ratio, cost of goods sold 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 in 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.
- Cost of goods sold (COGS) is a measurement of the production costs of goods and services for a company. 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 days inventory than companies that sell automobiles, like General Motors Co. (GM).
Example of Calculating Inventory Turnover
For the fiscal year ending January 2018, Wal-Mart Stores (WMT) reported annual sales of $500.34 billion, year-end inventory of $43.78 billion, and an annual cost of goods sold (or cost of sales) of $373.40 billion.
Walmart's inventory turnover for the year equals:
$373.40 billion ÷ $43.78 billion = 8.53
Its days inventory equal:
(1 ÷ 8.53) x 365 = 42 days
This indicates that Walmart sells its entire inventory within a 42-day period, which is quite impressive for such a large, global retailer.
The Bottom Line
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 or down or the economy is under-performing, it may show up as a lower inventory turnover ratio. Usually, a higher inventory turnover ratio is preferred, as it indicates that more sales are being generated given a certain amount of inventory.
Sometimes a very high inventory ratio could result in lost sales, as there is not enough inventory to meet demand. It is always important to compare the inventory turnover ratio to the industry benchmark to assess if a company is successfully managing its inventory.