Inventory Turnover Ratio: What It Is, How It Works, and Formula

Inventory Turnover

Investopedia / NoNo Flores

What Is Inventory Turnover?

Inventory turnover is a financial ratio showing how many times a company turned over its inventory relative to its cost of goods sold (COGS) in a given period. A company can then divide the days in the period, typically a fiscal year, by the inventory turnover ratio to calculate how many days it takes to sell its inventory, on average.

The inventory turnover ratio can help businesses make better decisions on pricing, manufacturing, marketing, and purchasing. It is one of the efficiency ratios measuring how effectively a company uses its assets.

Key Takeaways

  • Inventory turnover measures how efficiently a company uses its inventory by dividing the cost of goods sold by the average inventory value during the period.
  • Inventory turnover ratios are only useful for comparing similar companies, and are particularly important for retailers.
  • A relatively low inventory turnover ratio may be a sign of weak sales or excess inventory, while a higher ratio signals strong sales but may also indicate inadequate inventory stocking.
  • Accounting policies, rapid changes in costs, and seasonal factors may distort inventory turnover comparisons.

Reading The Inventory Turnover

Inventory Turnover Formula and Calculation

Inventory Turnover = COGS Average Value of Inventory where: 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

Average value of inventory is used to offset seasonality effects. It is calculated by adding the value of inventory at the end of a period to the value of inventory at the end of the prior period and dividing the sum by 2.

Cost of goods sold (COGS) is also known as cost of sales. Analysts use COGS instead of sales in the formula for inventory turnover because inventory is typically valued at cost, whereas the sales figure includes the company’s markup. Some companies may use sales instead of COGS in the calculation, which would tend to inflate the resulting ratio.

What Inventory Turnover Can Tell You

Inventory turnover measures how often a company replaces inventory relative to its cost of sales. Generally, the higher the ratio, the better.

A low inventory turnover ratio might be a sign of weak sales or excessive inventory, also known as overstocking. It could indicate a problem with a retail chain’s merchandising strategy, or inadequate marketing.

A high inventory turnover ratio, on the other hand, suggests strong sales. Alternatively, it could be the result of insufficient inventory. As problems go, ensuring a company has sufficient inventory to support strong sales is a better one to have than needing to scale down inventory because business is lagging.

A low inventory turnover ratio can be an advantage during periods of inflation or supply chain disruptions, if it reflects an inventory increase ahead of supplier price hikes or higher demand. Retail inventories fell sharply in the first year of the COVID-19 pandemic, leaving the industry scrambling to meet demand during the ensuing recovery.

The speed with which a company can turn over inventory is a critical measure of business performance. Retailers that turn inventory into sales faster tend to outperform comparable competitors. The longer an inventory item remains in stock, the higher its holding cost, and the lower the likelihood that customers will return to shop.

The fast fashion business is an example. Competitors including H&M and Zara typically limit runs and replace depleted inventory quickly with new items. Slow-selling items equate to higher holding costs. There is also the opportunity cost of low inventory turnover; an item that takes a long time to sell delays the stocking of new merchandise that might prove more popular.

A decline in the inventory turnover ratio may signal diminished demand, leading businesses to reduce output.

Inventory Turnover and Dead Stock

Inventory turnover is an especially important piece of data for maximizing efficiency in the sale of perishable and other time-sensitive goods. Examples include groceries, fashion, autos, and periodicals.

An overabundance of cashmere sweaters may lead to unsold inventory and lost profits, especially as seasons change and retailers restock accordingly. Such unsold stock is known as obsolete inventory, or dead stock.

Related Inventory Ratios

The inventory-to-saIes ratio is the inverse of the inventory turnover ratio, with the additional distinction that it compares inventories with net sales rather than the cost of sales.

Another ratio inverse to inventory turnover is days sales of inventory (DSI), marking the average number of days it takes to turn inventory into sales. DSI is calculated as average value of inventory divided by cost of sales or COGS, and multiplied by 365.

Example of an Inventory Turnover Calculation

Walmart Inc. (WMT)

For fiscal year 2022, Walmart Inc. (WMT) reported cost of sales of $429 billion and year-end inventory of $56.5 billion, up from $44.9 billion a year earlier.

Walmart’s inventory turnover ratio for the year was:

$429 billion ÷ [($56.5 billion + $44.9 billion)/2], or about 8.5

Its days inventory equaled:

(365 ÷ 8.75), or 42 days

This showed that Walmart turned over its inventory every 42 days on average during the year.

Limitations of Inventory Turnover

Inventory turnover is only useful for comparing similar companies, because the ratio varies widely by industry. For example, listed U.S. auto dealers turned over their inventory every 55 days on average in 2021, compared with 23 days for publicly traded food store chains.

A relatively high inventory turnover ratio might indicate insufficient stocking that is costing the company sales, while low inventory turnover could reflect bulk orders helping the company cut costs or preparations for a product launch, rather than inefficient inventory management.

Because the inventory turnover ratio uses cost of sales or COGS in its numerator, the result depends crucially on the company’s cost accounting policies and is sensitive to changes in costs. For example, a cost pool allocation to inventory might be recorded as an expense in future periods, affecting the average value of inventory used in the inventory turnover ratio’s denominator.

Meanwhile, if inventory turnover ratio increases as a result of discounts or closeouts, profitability and return on investment (ROI) might suffer.

How do you calculate inventory turnover?

Inventory turnover measures how efficiently a company uses its inventory by dividing its cost of sales, or cost of goods sold (COGS), by the average value of its inventory for the same period. It is an especially important efficiency ratio for retailers.

What is a good inventory turnover?

What counts as a “good” inventory turnover ratio will depend on the benchmark for a given industry. In general, industries stocking products that are relatively inexpensive will tend to have higher inventory turnover ratios than those selling big-ticket items.

Is high inventory turnover good or bad?

Companies will almost always aspire to have a high inventory turnover. After all, high inventory turnover reduces the amount of capital that they have tied up in their inventory. It also helps increase profitability by increasing revenue relative to fixed costs such as store leases, as well as the cost of labor. In some cases, however, high inventory turnover can be a sign of inadequate inventory that is costing the company sales.

How can inventory turnover be improved?

Some retailers may employ open-to-buy purchase budgeting or inventory management software to ensure that they’re stocking enough to maximize sales without wasting capital or taking unnecessary risks. Companies with localized supply chains and short production lead times may also use a pull-through production system, which procures the production materials and starts manufacturing only after a customer orders the finished product.

Article Sources
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